Transcript ECONOMICS 3150B

ECONOMICS 3200M
Lecture 5
Ch. 4, 5, 6
February 13, 2013
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Monopoly
• Assumptions:
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No price discrimination
Quality known by consumers
Substitutes available
Entry barriers
• Profit maximization pricing:
– MR=MC  [PM/MC] = [( +1)/] ( is the absolute value of the
price elasticity of demand)
– Price-cost mark-up – Lerner index of market power
– Relative mark-up inversely related to price elasticity of demand
– Constant elasticity of demand:  = ; therefore constant mark-up
• [PM/MC] = [+1]/ 
• Rule of thumb pricing – constant mark-up over costs where MC
approximated by AC
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Monopoly
• Profit maximization pricing over time:
– Price elasticity in long run may differ from price elasticity in short
run
– Case of oil:
• Inelastic short-run demand
• Elastic long-run demand as substitution possibilities expand
• Greenhouse gas emissions and carbon tax – initial level of tax
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Monopoly
• X-inefficiency
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Absence of competitive pressures to minimize costs
In competitive markets inefficient firms cannot survive
Agency problem, not a problem of monopoly
Incentives to innovate, invest in new technology
Carlton & Perloff: “A firm in a market with many firms can observe what
other firms are doing [assumes information freely available]. It can
observe, for example, whether its own costs of production are above or
below the market price. Because the market price reflects the efficiency of
the other firms in the market, a competitive firm knows that it can improve
its production efficiency if its costs of production are high relative to the
market price [how does it survive?]. In contrast, a monopoly has no other
firms to look at [other firms in other industries – who supplies the
technology and production equipment?] and may have no other standard
by which to judge how efficiently it is operating.”
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Monopsony
• Bargaining advantage
• Compare prices for inputs in competitive markets to
monopsony market
– Supply curve and marginal outlay curve facing monopsonist
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Monopoly
– Creating future competition
• Future demand depends on current levels of sales,
price expectations
• Recyclables – aluminum
• Substitutes – oil
• Durable or fashion products – defer purchases
– Planned obsolescence
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Monopoly
• Multi-product monopoly
• N products: Qi (i = 1,….,N)
• N prices: Pi
• General case: interdependent demands, interdependent costs
– Pi = Pi (Q1, Q2,…….., QN)
– Ci = Ci (Q1, Q2,…….., QN)
• Case 1: independent demands and costs
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Pi = Pi (Qi)
Ci = Ci (Qi)
N separate monopolies with first-order profit-maximization condition:
[(Pi M – MCi)/ Pi M ] = [1/ii]
Mark-ups can vary across products
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Monopoly
• Case 2: dependent demands, independent (i.e. separable) costs
– Pi = Pi (Q1, Q2,…….., QN)
– Ci = Ci (Qi)
– If all products i and j are substitutes: Dj / Pi > 0, then
[(Pi M – MCi)/ Pi M ] > [1/ii]
• Increase in Pi increases demand for Qj
– If all products i and j are complements: Dj / Pi < 0, then
[(Pi M – MCi)/ Pi M ] < [1/ii]
• Decrease in Pi increases demand for Qj
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Monopoly
• Case 3: independent demands, dependent costs
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Pi = Pi (Qi)
Ci = Ci (Q1, Q2,…….., QN)
First-order condition: MR1 = MR2 = …. = MRN = MC
Discriminating monopolist model
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Monopoly
• How does a monopoly come into existence?
• Superior management – development and execution of successful
competitive strategies and creation of large entry barriers and/or
reputation for retaliation against entrants
• Luck – innovation, access to key input
• Superior management and/or good luck
– Special knowledge to produce new or better product that other firms
cannot imitate at comparable costs or prevented by patents
– Special knowledge about production/organization technologies to produce
existing product at lower cost than competitors
• Depending upon size of cost advantage and industry demand, monopoly price
may be independent of costs of ex-competitors or price may be determined by
limit pricing
• Monopoly granted by government – natural monopoly, policy decision
(LCBO), political cronyism, rent-seeking
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Monopoly
• Rent-seeking: monopoly profits create incentive to invest in order to
win/gain profits/rents
• PV of monopoly profits depends upon discount rate, expected time
horizon for rents, magnitude of expected rents
• Duration and magnitude of future rents depend upon rent maintenance
activities and their success
• Competition through private or public markets – innovation (risktaking), strategic behavior, lobbying
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Monopoly
• Maintaining a monopoly
– Rent seeking – lobby for protection (regulation of entry, trade barriers)
– Lobbying to influence legislative outcomes and benefit company
• Competition in political markets – campaign contributions
• Hire officials from regulatory agencies or other areas of government – create
expectations of future payoffs in form of attractive job opportunities
– Strategic behavior
• Creation of entry barriers: limit pricing, predatory pricing, switching costs,
vertical controls
• Develop new competitive advantages
– Patents, copyright or trade secrets to maintain information advantage
– Difference between advertising/other forms of sales promotion, sales
commissions, payments to retailers for distribution, and bribes or
lobbying?
• Objective to generate/maintain economic rents  gain a competitive
advantage
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Prisoner’s Dilemma
• Aggressive competition
Firm B
Low Price
High Price
Low Price
$10, $10
$100, -$50
High Price
-$50, $100
$50, $50
Firm A
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Aggressive Competition
• Maximin strategy leads both firms to set “Low Price”, even though
both firms would be better off cooperating and setting “High Price”
• No cooperation because “one-time” game with no means for enforcing
cooperation agreement; i.e. getting even/punishing the other firm when
it reneges
• Overcapacity in number of industries indication of lack of cooperation
– steel, autos, plastics, computer chips, fibreoptic networks, wireless
networks, movie theaters, ATMs, and other industries in Southeast
Asia, North America and the European Union
• Price wars – airlines, supermarkets, long-distance and wireless telecom
services, computer companies, autos, steel
• Frequent flyer programs – no airline wants to go-it-alone and terminate
these programs even though all the airlines would be better off
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Prisoners’ Dilemma
Repeated Games
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Uncertain endpoint – encourages cooperation since there is possibility for
getting even and costs of revenge may outweigh benefits from reneging on
agreement (breaking ranks with cartel)
Shift focus for competition to difficult to detect, time-consuming to respond
strategies (instead of competing on price, compete on product
characteristics, marketing, technology, capacity, lobbying, etc.)
Fixed endpoint – back to prisoners’ dilemma model (strong incentive to
cheat, compete aggressively)
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Financially weak company at risk because financially stronger competitors more
likely to be aggressive to drive weak company into bankruptcy
Fly-by-night operators more likely to cheat customers, provide poor quality
products/services
Employment – layoffs (workers give advance notification); CEO with contract
to retire in fixed number of years (post-retirement benefits not tied to
performance or survival of company); weak incentives to perform
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Cartels
• Cooperation/collusion – tacit/explicit – among competitors in market
– Objective: generate monopoly profits since monopoly profits >
cumulative profits of incumbent competitors
• Prisoners’ dilemma
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2 identical firms with identical unit costs (C)
Cooperate: set PM (C) and split monopoly profits [M/2]
Do not cooperate: P=C and each receives =0
Only one cheats: sets P = PM -  to gain entire market and receive payoff
of M - ; other firm receives 0 (assuming no fixed costs)
– Dominant strategy (maximin strategy) for both firms in one-time game: do
not cooperate; cheat
– Repeated games with infinite time horizon or uncertain end-point (ability
to “get even”)
• Tit-for-tat: cooperate as long as other cooperates, do not cooperate if rival
cheats
• Problem: not credible because incentive to cooperate in future time periods
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Cartels
• Prisoners’ dilemma
– Repeated games with infinite time horizon or uncertain end-point (ability
to “get even”)
– Cooperate: split monopoly profits [M/2]
• PV of expected profits from cooperation = [M/2(1-)] [: discount rate =
1/(1+R)]
– Do not cooperate: each receives =0
• PV of expected profits = 0
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Only one cheats: receive payoff of M - 
Firms cooperate if [M/2(1-)] > M -  or 1 > 2(1- ) [>0.5]
With N firms, profit share from cooperation = [M/N]
Firms cooperate if [M/N(1-)] > M -  or 1 > N(1- ) [>1-1/N]
• Lim (N ) 1-1/N = 1 [ 1, R 0]
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Cartels
• Factors facilitating formation of cartels
– Ability to raise price without attracting entry – closeness of substitutes,
ease of entry
– Expected benefits form forming cartel exceed expected costs (negotiating
agreement, monitoring members, enforcing agreements, penalties for
violating competition laws)
– Symmetric cost structures and degree of vertical
integration/internalization
– Multi-market contact – possibility of local warfare spreading to other
markets
– Low costs for detecting cheating
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Few firms – monitor market shares
Prices widely known
Homogeneous product
Prices relatively insensitive to external factors – demand shocks, changes in
input costs
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Cartels
• Incentives for cheating – free rider
• Methods to prevent cheating
– Market-sharing arrangement
– Most favored nation clauses – seller guarantees buyer
that seller will not offer lower price to any other buyer
– Meet the competition clause – seller guarantees buyer
that it will match lowest price offered by competitors
– Trigger prices – if market price reaches trigger price
(agreed upon floor price), each firm will be free to
expand output to pre-cartel levels
– “MAD” strategy – mutually assured destruction
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Cartels
• Tacit collusion in highly concentrated markets
– Recognized industry leader – sets prices, others follow
– Regular price announcements
– Mark-up pricing
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Oligopoly
– No general theory
– Interdependence
• Strategy games
– Cooperation/collusion; aggressive competition
– One-time vs. repeated games
– Prisoners’ dilemma
• Getting even as enforcement mechanism
• Tit for tat strategy
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Oligopoly
• “Small” number of competitors – small undefined
• Strategic interactions among firms – small number implies
that each firm knows that strategies it selects will have
“significant” impact on profits of rival(s)
– Necessary to consider each rival’s behavior in order to select
optimal strategy for each instrument for competing in market
– Instruments for competing include: price, marketing strategies, cost
structures, product characteristics, distribution channels
– Each firm maximizes its profit given its beliefs how each rival will
behave
– 2 firm, 2 strategy example (dominant strategy):
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Oligopoly
Firm 2
Advertise
Don’t
Advertise
Advertise
$10, $5
$15, $0
Don’t
Advertise
$6, $8
$10, $2
Firm 1
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Oligopoly
• Non-cooperative game – one-time (single period) game
– Reputation and history unimportant – no possibility for learning
• Concept of Nash equilibrium
• Profits of firm 1 depend upon strategies selected by each of its M-1
competitors from strategy sets available:
– i = i (A1, A2, ……, AM)
• Strategy set for firm i (Ai) consists of Ti strategies
– Ai = {1i, ….., Tii}, where each strategy in the set () consists of values
for each of the K instruments (a) in strategy j (ji) for firm i
– ji = {aji1, ….., ajiK}
• Firm 1, given strategies selected by M-1 rivals, cannot do better by
choosing a strategy set other than the equilibrium set:
– i (A1*, A2*, …, Ai*, …, AM*)  i (A1*, A2*, …, Ai^, …, AM*)
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Oligopoly
• Dominant strategy
• Credible strategy
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Oligopoly
– High price dominant strategy for incumbent so threat of warfare not
credible – may lead to future entry
– Price warfare to deter first entrant and signal to future entrants (establish
credibility)
Potential
Entrant
Enter
Stay Out
High Price
$50, $10
$100, $0
Low Price
$30, -$10
$40, $0
Incumbent
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Oligopoly
• Simple case: 2 firms, single instrument and single strategy
in strategy set (K=1; T=1, M=2)
– Ai = {ai}
– 1 = 1 (a1, a2)
– First-order condition for profit-maximization:  1/  a1 , yields
reaction function
• a1 = R1 (a2)
– Nash equilibrium: pair of strategies (values for instruments) so that
• a1* = R1 (a2*) and a2* = R2 (a1*)
• Solution is intersection of reaction functions
• In Nash game, each firm ignores the effect of its decision on
behaviour of its rivals
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Oligopoly
• Simple case: 2 firms, single instrument and single strategy
in strategy set (K=1; T=1, M=2)
• Stackelberg leader: select optimal value for a1, given firm
2’s reaction function
Max 1 = 1 [a1, R2 (a1)]
First-order condition for profit-maximization: d 1/ d a1 , yields:
 1/  a1 +  1/  a2 * d a2/ d a1 = 0
Strategic substitutes: dR1/ da2 < 0 (reaction function downward
sloping)
– Strategic complements: dR1/ da2 > 0 (reaction function upward
sloping)
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Oligopoly
Bertrand competition
• Duopoly case – can be extended to M-firm oligopoly
• Homogeneous products, single instrument – P
• Identical costs structures: unit costs = C
• Strategic complements since reaction functions upward sloping – if
firm 1 decreases price, firm 2 must imitate otherwise suffers significant
loss of demand
• Nash equilibrium:
– P1 = P2 = C
– 1 = 2 = 0
• Different cost structures: C1 > C2
– Firm 2 drives firm 1 out be setting P = C1 - 
– Monopoly price if PM (C2) < P
– Constrained monopoly pricing (limit pricing) if PM (C2) > P
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P2 (P1, C2)
P1
P1 (P2, C1)
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P2
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