Transcript Market Power and Monopolistic Competition

Market Power and
Monopolistic Competition
Chapters 22 and 23.
Students should be able to:
• Describe the conditions that characterize markets with
monopoly, oligopoly, and monopolistic competition.
• Differentiate perfect competition, monopolistic
competition, and regulated and unregulated monopoly in
terms of output and price relative marginal cost and or
fixed costs.
• Discuss types of barriers of entry, entry deterrence
strategies and the consequences of uncontested
markets.
• Define price discrimination and discuss the costs and
benefits to the firm and society.
• Evaluate the difficulties of maintaining collusion
Market Power
• Market power is the ability of a firm to affect the
market price of a good to their advantage. In
declining order.
• Monopoly – A single producer without
competition
• Oligopoly Power – A small number of producers
sometimes acting in concert.
• Monopolistic Competition – Firms selling
differentiated products.
Price effects
• There is a demand curve relating the
quantity of a product that can be sold at a
given price.
• Invert the concept: For each quantity, there
is a price that the market may bare.
• Change the quantity and change that price
• Marginal revenue
Marginal Revenue
• For price taking firm, marginal revenue is
equal to price.
• For a firm with market power, marginal
revenue must include the change in the
price that results from a change in
quantity.
P
MR  P 
MR  P 
P
Q
Q
QP
P P  P(1  1
Q
P )
Example
35
Price
10000
20000
30000
40000
50000
60000
70000
80000
90000
100000
30
25
20
15
10
5
0
0
20000
40000
60000
Price
80000
MR
100000
120000
33
23.33452
19.05256
16.5
14.75805
13.47219
12.47283
11.66726
11
10.43552
MR
13.66905
10.48863
8.842323
7.790243
7.042918
6.476632
6.028302
5.661905
5.355163
Monopolist
• Maximize Revenues by choosing an
output level such that marginal revenue
equals marginal cost.
• Price will exceed marginal cost.
Monopolists will make greater profits than
a competitive firm.
• Profits should attract new entrants to the
market.
• Monopoly can only survive if there are
some barriers to entry.
35
30
20
ATC
P
Monopolist
25
15
D
10
MC
5
MR
0
0
20000
40000
60000
Q
80000
100000
120000
35
30
20
P
Monopolist
25
15
D
10
ATC
MR
MC
5
0
0
20000
40000
60000
Q
80000
100000
120000
35
30
20
P
Monopolist
Revenues
25
15
D
10
ATC
MR
MC
5
0
0
20000
40000
60000
Q
80000
100000
120000
Markups
• If a market is competitive, then price will
equal marginal cost.
• Degree of market power is often measured
as markup over marginal cost P  MC
P
• For monopolist, the MR = MC
MC  MR  P(1  1
P  MC
)
 1
P
P
P
The less elastic the demand curve, the higher
the market power.
Firm has more pricing power if good has
fewer substitutes.
Lerner Index
• Net markups are a measure of the market
power of a firm or industry. Referred to as
the Lerner index.
P  MC
P
• Rule of thumb for a monopolist,
MC  MR  P(1  1
P  MC
)
 1
P
P
P
– If markups are below this level, raise prices.
– If markups are above this level, lower prices.
35
30
20
P
Monopolist
Profits
25
15
D
10
ATC
MR
MC
5
0
0
20000
40000
60000
Q
80000
100000
120000
35
30
20
P
Price Taker
Profits
25
15
D
10
ATC
MR
MC
5
0
0
20000
40000
60000
Q
80000
100000
120000
Monopolist’s Schedule
Quantity
10000
20000
30000
40000
50000
60000
70000
80000
90000
100000
Price
33
23.33452
19.05256
16.5
14.75805
13.47219
12.47283
11.66726
11
10.43552
Revenue
330000
466690.5
571576.8
660000
737902.4
808331.6
873097.9
933381
990000
1043552
MR
13.66905
10.48863
8.842323
7.790243
7.042918
6.476632
6.028302
5.661905
5.355163
Cost
170000
238920.7
317411.1
402842.7
493837.2
589525.4
689301.8
792717.1
899422.9
1009140
ATC
17
11.94604
10.58037
10.07107
9.876744
9.825423
9.847169
9.908964
9.993587
10.0914
MC
6.892071
7.849039
8.543161
9.099448
9.568818
9.977642
10.34153
10.67057
10.97168
Profits
160000
227769.8
254165.7
257157.3
244065.2
218806.2
183796.1
140663.8
90577.14
Barriers to Entry
• Total Control over Vital Resource
– Alcoa in the aluminum market
– DeBeers in Diamond market
• Patents or Secret Formula:
– Xerox: Controlled photocopying
• Regulations: Jockey Club, SDTM
– Gambling is a legally restricted monopoly
• Returns to Scale:
– TownGas is an regulated monopoly supplier of a
particular type of piped natural gas (may have
competition from LNG)
35
30
20
ATC
P
Monopolist with high
fixed costs
25
15
D
10
MC
5
MR
0
0
20000
40000
60000
Q
80000
100000
120000
Surplus
• The demand curve represents how much
consumers are willing to pay for one more unit of a
good, if they have already bought a certain number
of goods.
• There are diminishing returns to any given product.
As people consume more of that product, the benefit
they get from consuming another one declines, and
they are only willing to pay a lower price.
• Difference between the price people are willing to
pay for a good (i.e. the position of the price
schedule) and the actual price is the consumer
surplus (net benefit to the consumer) generated by
that purchase.
P
11
10
Surplus
generated
by buying
first good
=6
10
9
9
8
8
7
7
6
6
5
5
4
P=3
4
3
3
2
2
1
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
P
11
10
Surplus
generated
by buying
second
good = 5
10
9
9
8
8
7
7
6
6
5
5
4
P=3
4
3
3
2
2
1
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
P
11
10
Total consumer
surplus is the
sum of surplus
of each good
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
P=3
2
2
1
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
P
11
When goods adjust
continuously, total
consumer surplus is
a triangle created by
price line and
demand curve
10
9
8
7
6
5
P
4
3
2
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
Producer Surplus
• Producers achieve profits whenever they
sell an extra goods at a price above the
cost of producing the extra good.
• Sum of profits for each good is the total
producer surplus, the area in the triangle
below the price line and above the supply
curve.
Competitive Market
Supply and Demand
P
Producer
Surplus
S
P*
D
Q*
Q
Competitive Equilibrium is Efficient
• Economic efficiency means that there are no
gains to be had at the level of society from
additional trades.
• If the price is higher or lower, the sum of the
areas of the consumer & producer surplus
triangles will be less than at the equilibrium
price.
• Economic efficiency does not guarantee that the
split of the surplus will coincide with any notion
of fairness.
Efficient Equilibrium Market
P 12
Consumer
Surplus
10
8
S
6
Producer
Surplus
P*
4
D
2
0
0
2
4
6
8
10
12
Q
Monopoly Price
P 12
D
10
S
8
P*6
Ceiling
4
2
0
0
2
Q*
4
6
8
10
12
Q
Total Societal Surplus is lower
under monopoly
P 12
Consumer
Surplus
10
Deadweight
Loss
S
8
6
4
Ceiling
Producer
Surplus
2
0
0
2
4
Q*
6
D
8
10
12
Q
Price Discrimination
• What if you don’t have to charge the same price
to everyone?
• If you have perfect knowledge of the valuation
applied to your product by each customer, you
might tailor your price for each one.
• Since lowering your price for each customer
doesn’t affect the price obtained from higher
value customers, you gain by selling at a price
above marginal cost.
P
P1
P2
11
10
9
9
8
P3
7
P4
6
P5
Total profit
earned by firm
10
8
7
6
5
5
4
P6
4
3
3
MC = 3
2
2
1
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
P
11
Perfect Price
Discrimination will
generate same output as
perfect competion, but
monopolist will take all
surplus as profit.
10
9
8
7
6
5
P
4
3
2
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
Consequences of Market Power
• One clear consequence of the existence of
market power is that prices are higher than
marginal cost and output is smaller than
perfect competition.
• Additional consequences of the presence of
market power may be:
– Complacency by firms managers (i.e. standard
corporate governance measures do not
generate efficiency)
– Rent-seeking: Firms may put effort into
constructing artificial barriers to entry rather
than producing goods.
Contestable Markets
and Strategies to Deter Entry
• A monopoly firm may not set profit maximizing
prices because they want to keep the price low
enough to keep other firms out.
• A market in which the possibility of market entry
tempers the behaviors of monopolists is called a
contestable market.
– A pricing strategy to prevent entry is called limit
pricing.
• Firms may also use other strategies to deter
entry which are less beneficial than lowering
prices and increasing production.
Strategies of Entry Deterrence
• A firm may deter entry by competitors by
threatening them with :
– Engaging in predatory pricing.
• Price below marginal cost to drive another firm out
of the market.
– Building excess capacity (promise predatory
pricing)
Oligopoly
• Many industries are dominated by a small
number of firms: Airlines, airplane
manufacturing, supermarkets, drugstores.
• In theory, even a small number of firms may
compete, driving down prices to the level of
costs.
– Airplane manufacturing: Boeing vs. Airbus
• Oligopolists may also collude!
– OPEC
– Sotheby’s and Christie’s
Conditions of Cartel
• Small number of firms
• Barriers to Entry
• Ineffective or Non-existent government
regulation.
• Way to Stop Cheating
–Enforcer
–Capacity Constraints (California
Electricity Market)
Duopolists
• Two companies can agree on a price at which they could
make profits.
• If the other firm keeps its word, you can win whole
market by undercutting their price.
• If the other firm doesn’t keep its word, you must undercut
the agreed upon price or lose everything.
• Either way, best strategy is to cheat on agreement.
Q
P
50
75
100
125
150
175
200
225
550
525
500
475
450
425
400
375
Revenue MR
27500
39375
50000
59375
67500
74375
80000
84375
475
425
375
325
275
225
175
Cost
ATC
MC
18750
375
28125
375
37500
375
46875
375
56250
375
65625
375
75000
375
84375
375
Profit
375
375
375
375
375
375
375
375
8750
11250
12500
12500
11250
8750
5000
0
Split
4375
5625
6250
6250
5625
4375
2500
Cheat
11250
12500
12500
11250
8750
5000
0
Payoff Matrix
• Two firms
• Each one could choose to
collude and charge a
price of 475.
• Or each could decide to
cheat, steal the market
for themselves and
charge a price of 450
• The matrix describes the
payoff of each firm given
the strategies of another.
Red Firm 1
Collude
Blue
Firm
2
Cheat
Collude 6250,
6250
0,
11,250
Cheat
5625
5625
11,250,
0
Game Theory & Beautiful Mind
• Game Theory is a branch of math that describes
strategic interactions.
• Nash describes a game that is in equilibrium as
one in which no player has an incentive to
change their strategy given the strategy of the
other player.
• Nash equilibrium in the above game is for both
to cheat even though they both players would be
better off if they could collude.
California, 2000
• In 1998, utilities in California’s deregulated
wholesale power market were paying between
$30 and $40 per MWH. By summer and fall of
2000, prices skyrocketed to $140.
• Five firms producing wholesale electricity
(Enron, Dynegy,…). When there is excess
capacity, five firm market behaved relatively
competitively.
• When capacity constraints hit, firms could
exercise significant pricing power and raise
prices above marginal cost.
Sotheby’s and Christies
Prior to 1995, Sotheby's and Christie's, the world's largest auction houses,
were in fierce competition for consignments from sellers. ,… . In March 1995,
this competition abruptly ended. Christie's … would charge sellers a fixed,
non-negotiable commission … and a month later Sotheby's announced the
same policies. Detailed documents kept by …, Christie's former chief
executive, show that the abrupt change was due to a price-fixing conspiracy.
Why were these firms able to
successfully form a cartel?
Anatomy of the Rise and Fall of a PriceFixing Conspiracy: Auctions at Sotheby's
and Christie's
Orley Ashenfelter and Kathryn Graddy *
Firms may compare future profits from staying
in cartel relative to current profits from
cheating. In lean markets, the benefits from
cheating may be less than the future benefits
from staying in a cartel.
Boeing vs. Airbus.
• Why might it be difficult for two airlines to
collude.
• There is a large stock of existing aircraft
available for sale in used market.
• Durable goods producers have to compete
with their own past.
• Some economists claim that Alcoa did not
have a monopoly because the broad
supply of recycled Aluminum.
Natural Monopoly
• In markets with a natural monopoly there
may be one firm.
• Economies of scale indicate that at marginal
cost pricing firms make a loss.
• Efficient production involves 1 firm. Firm will
naturally charge markup and earn profits.
• Government may step in, usually to put a
maximum price level. Should be minimum
amount necessary to get the firm to operate
– Average cost pricing
Monopoly
P
600
D
500
Average
Cost
Pricing
ATC
400
MC
300
200
MR
Competition
100
0
0
50
100
150
200
250
Q
Difficulty with Regulation
• Competitive Markets are Self-Regulating. Many
individual agents will be making small decisions
that lead to a competitive outcome.
• If single decision maker, information problems
become acute.
– East Tunnel – What is the proper return that a
company should be entitled to. What is the true ATC.
– How do you insure investment that will minimize ATC.
Does TownGas generate excessive
profits?
High operating profit to
turnover ratio, but this
may be a function of high
capital costs.
Return on Assets seems
pretty good.
2004
Operating Profit
Turnover
Assets
3356.7
8154
15175.9
41.17%
22.12%
Monopolistic Competition
• Most firms produce a good that is (to a
certain extent) unique. No other good has
the exact same properties.
– Coke, Pepsi, President’s Choice
• To the extent that you are a unique
producer, you will have some market power.
• Price elasticity of individual products are
larger than total category. But not infinite as
in the case of commodity goods.
Monopolistic
Competition
Short-Run
35
30
25
D
20
15
ATC
10
5
MC
MR
0
0
20000
40000
60000
80000 100000 120000 140000 160000
Characteristics of Monopolistically
Competitive Markets
• Differentiated Products
• Free Entry into very similar markets.
• Individual firms face downward sloping
demand curve and a falling average total
cost curve.
– They would sell more if they could at the
going rate but lowering their prices to sell
more would lead to losses.
No Barriers to Entry
• What happens if new firms can enter?
• If there are profits to be had,
entrepreneurs will enter markets to provide
close substitutes for profit making goods.
• New goods splitting the market and better
substitutes means lower, flatter demand
curve.
Monopolistic
16
P
Competition
14
Long Run
12
ATC
Not operating
at minimum of
ATC
10
D
8
Monopoly
Power but
zero profits
6
4
MC
2
MR
0
0
10000
20000
30000
40000
50000
60000
Q
Monopolistic Competition vs.
Perfect Competition
• On a market-by-market basis, perfect
competition will offer greater efficiency
both in terms of minimizing deadweight
losses and encouraging an efficient
production scale.
• Monopolistic Competition only occurs with
differentiated products.
– Greater variety generated by this market may
compensate for loss of efficiency.
Monopolistic Competition and
Entrepreneurship
• New markets are frequently developed.
• For many goods, the only barriers to entry
is imagination.
• Entrepreneurs develop new ideas for new
goods. The pay-off for entrepreneurship
are short-run monopoly profits. (Ted
Turner and CNN). Only in rare cases will
firms be able to make long-term
monopolistic profits.