Transcript monopolistically competitive. - LMS

Pure Competition and
Monopolistic Competition
Chapter 8
• Pure competition is a standard against which other
market structures are compared. The product is
perfectly undifferentiated.
• When there are many firms, but the product is
differentiated, the market is monopolistically
competitive.
» This brand competition may involve advertising
campaigns and large promotional expenditures to
stress often minor distinctions among products
2005 South-Western Publishing
Slide 1
Michael Porter’s Five Forces of Competitive Advantage
The forces that determine competitive advantage are:
1. Substitutes (threat of substitutes can be offset by brands and
special functions served by the product).
2. Potential Entrants (threat of entrants can be reduced by
high fixed costs, scale economies, restriction of access to
distribution channels, or product differentiation).
3. Buyer Power (threat of concentration of buyers).
4. Supplier Power (threats from concentrated suppliers of key
inputs affect profitability).
5. Intensity of Rivalry (market concentration, price
competition tactics, exit barriers, amount of fixed costs, and
industry growth rates impact profitability).
Slide 2
Figure 10.2 on Page 433
Potential entrants
Substitutes
Value-price gap
Branded vs. generic
Sustainable
industry
profitability
High capital requirements
Economies of scale
Absolute cost advantages
High switching costs
Lack of access to distribution
channels
Product differentiation
Public policy constraints
Intensity of rivalry
Buyer power
Industrial concentration
Pricing tactics
Switching costs
Exit barriers
Cost fixity
Industrial growth rates
Buyer concentration
Overcapacity
Homogeneity of buyers
Potential of integration
Outside alternatives
Supplier power
Unique suppliers
Number of suppliers
Supply shortages or surplus
Degree of vertical integration
Slide 3
What Went Wrong
With Xerox?
• After inventing chemical paper copiers, Xerox
enjoyed 15% growth rates in the 1960s and 70’s.
• As their patents expired, new rivals such as
Ricoh and Cannon aimed their copiers at smaller
businesses and smaller volume users.
• Xerox continued to build all parts in-house and
suffered from serious price competition. Xerox’s
strategy led to erosion of its once dominant
status to that of an also-ran.
Slide 4
Break-even Sales Change Analysis
•
•
•
•
The price-cost margin percentage (pCM) is defined as
pCM = ( P – MC )/P.
A price cut may help or hurt profitability depending on price
elasticities and price cost margins.
Ask how much quantity must output change after a price cut to
breakeven (from before the price cut).
If we cut prices 10%, to breakeven the percentage change in quantity
(DQ/Q) must be large enough to satisfy the equation to breakeven:
pCM / (pCM% – .10) < (1 + DQ/Q )
•
•
•
The larger is the price-cost margin percentage, the smaller will be the
necessary quantity response to justify cutting price.
If pCM is 80%, then .8/(.8-.1) = 1.14. Hence, a 10% cut in price
must be offset by at least a 14% increase in quantity to breakeven.
If pCM is only 20%, then .2/(.2-.1) = 2. Hence, a 10% cut in price
must be offset by at least a 20% increase in quantity to breakeven.
Slide 5
The Relevant Market Concept
• A market is a group of economic agents that interact in a
buyer-seller relationship. The number and size of the
buyers and sellers affect the nature of that relationship.
• A popular measure of concentration is the percentage of an
industry comprised of the top 4 firms. Similarly, the
market share held by the top 4 buyers is a popular measure
of buyer concentration.
• The relationship among firms is affected by:
a. the number of firms and their relative sizes.
b. whether the product is differentiated or standardized.
c. whether decisions by firms are independent or
coordinated (collusion).
Slide 6
A Continuum of Market Structures:
Competition
Pure Competition assumes:
1.
2.
3.
4.
a very large number of buyers and sellers
homogeneous product (standardized)
complete knowledge of all relevant market
information
free entry and exit (no barriers)
These assumptions imply several things about
competitive markets, including price equals
marginal cost.
Slide 7
A Continuum of Market Structures:
Monopoly
Monopoly assumes:
1.
2.
3.
4.
Only one firm in the market area
Low cross price elasticity with other products.
No interdependence with other competitors.
Substantial entry barriers
These assumptions imply several things about
monopolies, including that the monopoly price is
well above marginal cost. Monopoly is discussed
in full in Chapter 11.
Slide 8
A Continuum of Market Structures:
Monopolistic Competition
Monopolistic competition assumes:
1.
2.
3.
4.
A large number of firms, some of which may be
dominant in size
Differentiated products
Independent decision making by individual firms
Easy entry and exit
These assumptions imply several things about
monopolistic competition, including that the price in the
long run is equal to average cost.
Slide 9
A Continuum of Market Structures:
Oligopoly
Oligopoly assumes:
1.
2.
3.
Only a few firms in the market area
Products may be differentiated or undifferentiated
There is a large degree of interdependence with other
competitors
These assumptions imply several things about
monopolies, including that the monopoly price is well
above marginal cost. Chapter 12 discusses oligopoly
markets.
Slide 10
Price-Output Determination
Under Pure Competition
Competitive firms attempt to maximize profits.
Competitive firms cannot charge more than the market
price of others, since their product is identical to all
others.
Hence, competitive firms are price
takers.
Total revenue, TR, is P·Q, where price is given.
Therefore, marginal revenue, MR, is price, P.
Profit is total revenue minus total cost  = TR - TC).
Slide 11
Profit maximization implies that each firm produces an
output where Price = Marginal Cost (P = MC).
» To produce more than this quantity implies that P
< MC, which is not the most profitable decision.
» To produce less than where P=MC, implies that
P > MC, and the firm could increase profits by
expanding output.
• In short run, a competitive firm may earn
economic profits.
• In long run, entry pushes price down to the minimum
point of the average cost curve, so that economic
profits are zero.
Slide 12
Equilibrium Price in a Competitive Market
• Equilibrium for each firm if
P = MC. Each firm is
“happy”
• Equilibrium for the industry
if: Demand equals Supply at
the going price
» When both occur, the market is
in a Competitive Equilibrium
MC
MC
AC
D
a firm
the industry
CAN EARN ECON PROFITS
IN THE SHORT RUN
Slide 13
1.
2.
A Competitive Equilibrium Implies:
Competitive firm can earn positive
economic profits in the SR
If Price < AVC, firm will shut down
so-called “shut down price” is lowest AVC
MC
AC
Pmin AC
shut down price
3.
In LR, entry forces price down to the
minimum of the AC curve
AVC
Slide 14
PROBLEM: The following is given:
For the industry:
QS = 3000 + 200 P and
QD = 13500 - 500 P
For the firm:
FC = 50
MC = 3 Q
FIND OPTIMAL output for this firm.
Slide 15
Answer: Find equilibrium price. Set D = S
we see 3,000 + 200 P = 13,500 - 500 P. This
implies:
10,500 / 700 = P = $15.
At this price, the firm produces where
P = MC, so
15 = 3 Q
Q=5
Slide 16
Monopolistic Competition
• Monopolistic Competition
» MARKET STRUCTURE
• Many Firms and Many Buyers
• Easy Entry & Exit
• PRODUCT DIFFERENTIATION ! ! !
• Historical Background
» Joan Robinson “Economics of Imperfect
Competition,” 1933
» Edward Chamberlin, “Theory of
Monopolistic Competition, 1933
• Small Groups & Large Groups
Product
Differentiation
Among Gas
Stations
Slide 17
Product Differentiation
• Differentiation occurs when consumers perceive that a
product differs from its competition on any physical or
nonphysical characteristic, including price.
• Examples: restaurants, dealer-owned gas stations, Video
rental stores, book & convenience stores, etc.
• Assumptions of the Model:
» Large number of firms
» Differentiated Product
» Conditions of Cost and Demand are Similar
» Easy Entry & Exit
Slide 18
Basic Model of
Monopolistic Competition
MC
• In the Short Run
» produce where MR= MC
» price on the demand curve
• NOTICE:
PM
AC
» P > MC
» economic profits exist
P > AC
» there exists incentives for
entry into this industry
SHORT RUN DIAGRAM
D
QM
MR
Slide 19
Profits in the SR Induces Entry
• Entry in this industry “steals”
customers.
• Demand curve shifts inward
• RESULTS
» MR = MC (like monopoly)
P
» P = AC (like competition)
» Profits in LR are zero (like
competition)
» not at Least Cost Point of AC curve
(like monopoly)
MC
AC
D
D’
Q
MR
LONG RUN DIAGRAM
Slide 20
Properties of Monopolistic Competition
• Inefficient Production
» EXCESS CAPACITY
• not at least cost
point of AC curve
» Could Avoid Excess
Capacity by JOINTLY
PRODUCING at the
same plant
• Kroger Salt & Morton
Salt at same plant
• Sears’ Kenmore and
Whirlpool built at same
factory.
• Does the expectation of
zero profits in the future
stifle innovation?
• Is there too much
product differentiation?
Slide 21
Selling and Promotional Expenses
• Suppose that the price is determined outside of the model, as with
liquor prices in some States.
• We will expand promotional activities until the extra profit
associated with the activity equals the extra cost of the promotion.
• This decision rule for Optimal Advertising is when:
Contribution Margin = Marginal Cost of Advertising
or
P – MC = k • DA/DQ
• or expand advertising whenever (P – MC)( DQ/DA) > k
• where, contribution (P – MC) is the marginal profit contribution
of an additional sale, and the marginal cost of advertising is
( k • DA/DQ).
Slide 22
Example
• To sell one more unit of output will cost the price of the
added message, k, divided by the marginal product of
a dollar of advertising (DQ/DA).
• If a radio message costs $1000, and if that message
yields 5 new items sold, then the marginal cost of
advertising is $200, ($1000 /marginal product of
advertising).
• If it costs $200 to sell one more car (MCA=$200), and
if the contribution of another car sold is $300 to profits,
then we should expand promotional expenses.
Slide 23
What Went Wrong With
Amazon.com
• Stocks only 1,000 books but displays 2.5
million
• Barnes & Noble and Borders are profitable,
but Amazon didn’t earn a profit
• Classic example of a business with low
barriers to entry
• Internet buyers are very price conscience, as
they can shop multiple sites with
MySimon.com and others
Slide 24
Competitive Markets Under
Asymmetric Information
• Used car: who knows what about it?
• Asymmetric Information -- unequal or
dissimilar knowledge among market
participants.
• Incomplete Information -- uncertain
knowledge of payoffs, choices, or types of
opponents a market player faces.
Slide 25
Search Goods versus Experience Goods
• Search goods are products or services whose quality is
best detected through a market search.
• Experience goods are products and services whose
quality is undetected when purchased.
• Warranties and firm reputations are used to assure quality.
• But if someone is selling his or her car, isn't it likely that
the car is no good? Is it a lemon?
» This is an explanation why used car prices are
so much lower than new car prices.
• If one firm defrauds customers, how do the reputable firms
signal that they are NOT like the fraudulent firm?
Slide 26
Adverse Selection
and the Notorious Firm
• Suppose that a firm may decide to produce
a High Quality or Low Quality product,
and the buyer may decide to offer a High
Price or a Low Price.
• Since the firm fears that if it offers a High Quality
product but that buyers only offer a Low Price,
they only produce Low Quality products and
receive Low Prices.
• This is the problem of adverse selection
Slide 27
Notorious Firm Analysis
Payoffs in the boxes
are for the seller only
• Simultaneous decisions
BUYER
of buyer & seller
Hi Price Low Price
• A risk averse decision
High
by the firm is to make a
70
Quality 130
Low Quality product SELLER
• Best for the buyer is a
Low
150
90
Quality
low price, but a high
quality good. Worst for
We end in a trap of only
the buyer is a high price
poor quality goods at
but a low quality good.
low prices.
Slide 28
Solutions to the Problem of
Adverse Selection
• Regulation (Disclosure Laws, Truth in Lending)
• Long term relationships, or reliance
relationships
• Brand names (a form of a “hostage” to quality)
• Nonredeployable assets are assets that have
little value in another other use
Example: Dixie Cups made with paper-cup machinery
which cannot be used for other purposes — if Dixie Cups
leak, the company is in trouble
Slide 29