Frank

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Frank Bernanke Chapters 9 10 Imperfect
competition
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Outline

• Monopoly
• Monopoly power
• Barriers to entry
• Natural monopoly
• Profit maximization by a monopolist
• Efficiency of imperfect competition
• Other forms of imperfect competition
• Oligopoly and monopolistic competition
• Game theory
• Oligopoly models
• The kinked demand curve model
• Cartels and collusion

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Price Taker v. Price Setter

• Perfectly Competitive Firm
• A firm that must take the price in the market
• A price taker
• Imperfectly Competitive Firm
• A firm with at least some latitude to set its own
  price
• A price setter

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Forms of Imperfect Competition

• Pure monopoly
• A firm thats the only supplier of a unique
  product with no close substitutes
• Oligopoly
• A market with a handful of firms (2-12) producing
  a product for which only rival firms produce
  close substitutes
• Monopolistic competition
• A market with a large number of firms that
  produce slightly differentiated products that are
  reasonably close substitutes for one another.

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Competition v. imperfect competition

• A perfectly competitive firm faces a perfectly
  elastic demand curve for its product
• Firms take the price in the market, where supply
  and demand curves intersect
• Charging a higher price or a lower price does not
  help increase profits
• An imperfectly competitive firm faces a
  downward-sloping demand curve
• Charging a price different from competitors may
  be advantageous

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Pure Monopoly

• Very rare on a global scale (DeBeers?)
• Not as rare
• Local/regional monopoly
• Firms with a lot of market power

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Market Power

• Monopoly Power (Market Power)
• A firms ability to raise the price of a good
  without losing all its sales
• It does not mean that a firm can sell any
  quantity at any price it wishes (if firms raise
  price, quantity demanded falls).
• i.e. they must remember the law of demand

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Sources of Market Power

• Market power arises from factors that limit
  competition barriers to entry
• Something prevents other firms from entering the
  market

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Barriers to Entry

• Economic barriers
• Exclusive control over inputs (DeBeers, ALCOA)
• Economies of scale (lower average costs)
• Natural monopoly
• Legal barriers
• Patents
• Grant exclusive rights for a specified time
  period
• Promote monopoly but encourage innovation
• Government licenses or franchises
• Technological barriers
• Tech superiority
• Tech may give rise to natural monopoly

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Economies of Scale Natural Monopoly

• With Economies of scale (a.k.a. increasing
  returns to scale)
• Average cost of production falls as output
  increases
• High start-up (fixed) costs followed by low
  marginal costs
• Suggests larger firms will be more efficient than
  smaller firms
• When we see firms merge, we can assume that they
  are achieving economies of scale (lower average
  costs and higher per unit profit) by doing so
• When is IRTS likely to happen?
• What are some examples of goods or services where
  firms have merged?

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Total and Average Costs for a Production Process
with Economies of Scale
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Natural Monopoly

• In some markets, it makes more sense (is more
  efficient) to only have a single provider of the
  good.
• Economies of scale are so great that the good or
  service can be provided at the lowest cost if
  only one firm provides it.
• E.g. Utilities
• How many sets of phone lines, water pipes, cable
  wires, electric lines do we need?
• Since monopoly power is dangerous (to consumers)
  what must we do with natural monopolies?

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Returns to Scale

• Increasing returns to scale
• When all inputs are changed by a given proportion
  and output changes by a higher proportion
• Also know as Economies of Scale
• Constant returns to scale
• When all inputs are changed by a given proportion
  and output changes by the same proportion
• Decreasing returns to scale
• When all inputs are changed by a given proportion
  and output changes by a lower proportion
• Firm is too big

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Returns to scale

• Reasons for IRTS
• Increased ability for division of labor
  (specialization)
• More output may justify the use of high-tech
  capital
• Inputs can be purchased in bulk
• By-product can be reused/resold
• Reasons for DRTS
• Thick corporate hierarchy slows decision-making
• Less oversight may result in more
  shirking/disconnect from labor

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Profit maximization by a monopolist

• Monopolists general strategy
• Restrict output
• Stimulate demand
• Monopolist must determine both Q P

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Monopolists Marginal Revenue

• Marginal Revenue
• The change in a firms total revenue that results
  from a one-unit change in output
• For a monopolist
• marginal revenue from selling an additional unit
  is less than the market price
• Note that a monopolist can only sell an
  additional unit if it cuts prices on all units it
  sells (i.e. the seller does not engage in price
  discrimination)

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Aside Price Discrimination

• Price Discrimination
• The practice of charging different buyers
  different prices for essentially the same good or
  service
• Discounts to senior citizens, children
• Discounts on air travel depending on days of
  travel
• Rebates or coupons on retail merchandise
• Novel sales
• Effective when the good or service cannot be
  resold

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Types of Price Discrimination

• Perfect price discrimination
• A firm that charges each buyer exactly his or her
  reservation price (rare)
• Hurdle method of price discrimination
• The practice by which a seller offers a discount
  to all buyers who overcome some obstacle
• A rebate that takes time and effort to mail in
• Time spent waiting
• Staying over a weekend on air travel

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Benefits of Price Discrimination

• The number of trades increase
• Brings output closer to the socially efficient
  level
• Reduces efficiency loss associated with market
  power and increases total economic surplus

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The Demand Curves Facing Perfectly and
Imperfectly Competitive Firms
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The Monopolists Benefit from Selling an
Additional Unit
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Marginal Revenue in Graphical Form
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Profit Maximization

• Goal of all firms Maximize profits
• Rule
• Expand output when MR gt MC
• Decrease output when MC gt MR
• Sell the quantity of output where marginal
  revenue equals marginal cost, MR MC

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The Profit-Maximizing Output Level for a
Perfectly Competitive Melon Farmer
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Profit-Maximizing Rule

• Firm with market power must set quantity and
  price
• Profit is maximized at the level of output for
  which MR MC
• A monopolist sets the price off of the demand
  curve at its profit-maximizing output

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The Monopolists Profit-Maximizing Output Level
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Monopoly and Efficiency

• Recall, the market efficient level of output is
  where MB MC
• The monopolist produces less than socially
  efficient level of output
• Monopolists are not efficient
• Inefficiency is measured by deadweight loss
• Monopoly may be socially inefficient, but the
  alternatives, like legislation, are not perfect
  either

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The Deadweight Loss from Monopoly
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Chapter 10 Thinking Strategically
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Oligopoly

• A handful of big firms selling a product with
  some quality differentiation
• Rule of thumb if 4 biggest players together have
  40 or more of total market share
• Chips
• Soda
• Beer
• Airlines
• Insurance
• Cell phone providers
• Automobiles
• Cigarettes
• Athletic shoes
• Online travel booking sites

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Profit in oligopoly?

• Do these firms make economic profit gt 0?
• Do these profits persist into the long-run?
• What must be true?

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The kinked demand curve model of Oligopoly

• Observation prices in oligopoly markets tend to
  change very slowly.
• Why?
• Assume no cooperation or collusion among firms
• Considering the relationship between price
  changes, elasticity of demand and revenue changes
  helps explain this observation.
• Individual firms are basically afraid to change
  price because of what other firms might do.

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Kinked Demand Curve

• Assume that we have 3 firms A, B, C
• Products are similar
• The shape of the demand curve for As product
  tells us how much QD changes when there is a
  price change (elasticity) this depends on the
  pricing behavior and similarity of the
  substitutes B and C.

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Kinked Demand Curve

• Consider what might happen if firm A changes
  price
• 1. If firm A lowers price then B and C can follow
  the price change or ignore it.
• If B and C follow then they also lower price
  because they are afraid of losing their market
  share to firm A.
• If B and C ignore the price change by A, then
  they maintain the higher price because they dont
  believe that people will switch.
• 2. If firm A raises price then B and C can follow
  the price change or ignore it.
• If B and C follow then they also raise price
  because they dont believe that people will
  switch, so they can increase profits by also
  charging more.
• If B and C ignore the price change by A, then
  they maintain the lower price because they
  believe that people will switch, and they can
  capture some of firm As market share by having a
  lower price.

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Kinked Demand Curve

• If competitors B and C consider their product to
  be a reasonable substitute for As product, they
  are likely to ignore (not follow) a price
  increase and follow a price decrease
• If A raises price and B and C do not follow
• consumers are more likely to substitute toward B
  and C
• increase in the Price of A gt big decrease in QD
  for A
• If the other firms do not follow the price
  increase then the demand for As product will be
  relatively ELASTIC (flat slope) at prices above
  the current price.
• If A lowers price and B and C do follow
• consumers are less likely to substitute toward B
  and C
• decrease in the Price of A gt small increase in
  QD for A
• If the other firms do follow the price decrease,
  then the demand for As product is going to be
  relatively INELASTIC (steep slope) at prices
  below the current price.

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Kinked Demand Curve

• When firms believe that their product is a close
  substitute for their competitors product, they
  do not have much incentive to change price
• A price decrease will be matched, so they have
  nothing to gain by lowering price.
• A price increase will not be matched, so they
  have a lot to lose by raising price.

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Theory of Games

• The payoff of many actions depends upon the
  actions of others
• For example, an imperfectly competitive firm
  must weigh the responses of rivals when deciding
  whether to cut their prices
• The decisions of competing firms are often
  interdependent

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Game theory

• A mathematical technique for analyzing the
  decisions of interdependent oligopolistic firms
  in uncertain situations.
• History
• Cournot (1838) 1st observations on oligopoly
  behavior
• Darwin (1878) competition and evolutionary bio
• Von Nuemann (1928) minimax strategy
• Dresher and Flood (1950) The prisoners dilemma
• Nash (1950-1953, 1994) Bargaining theory and Nash
  equilibria

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Game Theory

• A game is simply a competitive situation where
  two or more firms or individuals pursue their
  interests and no person can dictate the final
  outcome or payoff.
• Players choose their strategy without certain
  knowledge of the other players strategies, but
  may eventually learn which way the opposition is
  leaning.

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Elements of a Game

• Basic elements
• The players
• The strategies
• The payoffs
• Payoff matrix
• The fundamental tool of game theory.
• This is simply a way of organizing the potential
  outcomes of a given game in a table that
  describes the payoffs in a game for each possible
  combination of strategies

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Strategies

• Dominant strategy
• A strategy that yields a higher payoff no matter
  what the other players in a game choose
• Dominated strategy
• Any other strategy available to a player who has
  a dominant strategy
• Nash Equilibrium
• Any combination of strategies in which each
  players strategy is his best choice, given the
  other players strategies.
• IOW Nash equilibrium is achieved when all
  players are playing their best strategy given
  what the other players are doing.
• Nash equilibrium does not necessarily mean the
  best payoff for all the players a better payoff
  may be achieved through collusion.

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A simple game and payoff matrix

• Duopoly situation each of the two firms A and B
  must decide whether to mount an expensive
  advertising campaign.
• If each firm decides not to advertise, each will
  earn a profit of 50,000.
• If one firm advertises and the other does not,
  the firm that does will increase its profits by
  50 to 75,000, and drive the competition into a
  loss.
• If both firms advertise, they will earn 10,000
  each because the advertising expense forced by
  competition wipes out large profits

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Example continued

• If firms could agree to collude, the optimal
  strategy would obviously be to not advertise
  maximize joint profits 100,000
• Lets assume they cannot collude, and therefore
  do not know what the competition is doing.
• A Dominant Strategy is the one that is best no
  matter what the opposition does.

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The Payoff Matrix

• Firm B
• Dont
  Advertise Advertise
• Dont
• Advertise
• Firm A
• Advertise

A profit 50 B profit 50
A loss 25 B profit 75
A profit 75 B loss 25
A profit 10 B profit 10
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New Game The Prisoners Dilemma

• You and your friend Bugsy are the prime suspects
  for knocking over a liquor store. The cops pick
  you up, and immediately after your arrest you and
  Bugsy are separated and questioned individually
  by the DA. Without a confession, the DA has
  insufficient evidence for a conviction. During
  your interrogation, you are told the following
• The police do have sufficient evidence to convict
  you and Bugsy of a lesser crime.
• If you and Bugsy both confess to the liquor store
  heist, you will each get a 5 year sentence.
• If neither of you confesses, you will each be
  charged with the lesser crime, and sent up the
  river for 1 year.
• If Bugsy confesses (turns states evidence) and
  you do not, Bugsy will go free while you will be
  convicted of the liquor store robbery and get
  sent to the big house for 7 years.
• Bugsy is told the exact same information.
• What will you do?

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The Payoff Matrix

• You
• 
  Dont Confess Confess
• Dont
• Confess
• Bugsy
• Confess

Bugsy 1 year You 1 year
Bugsy 7 years You Free
Bugsy Free You 7 years
Bugsy 5 years You 5 years
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Prisoners Dilemma

• Prisoners Dilemma
• Each player has a dominant strategy
• It results in payoffs that are smaller than if
  each had played a dominated strategy
• Produces conflict between narrow self-interest of
  individuals and the broader interest of larger
  communities

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Naturalist applications of prisoners dilemma

• Why do people shout at parties?
• Why does everyone stand up at concerts?

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There are some games where one player does not
have a dominant strategy but the outcome is
predictable

• A
• 
  Left Right
• Top
• B
• Bottom
• As behavior is predictable in this case.

B 100 A 0
B 100 A 100
B -100 A 0
B 200 A 100
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One more

• A
• Left Right
• Top
• B
• Bottom
• Here, As behavior is again predictable choose
  Right is the dominant strategy but now B stands
  to lose a great deal if by chance A chooses left
  instead

B 100 A 0
B 100 A 100
B -10,000 A 0
B 200 A 100
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Cartels

• Cartel
• A group of firms who sell a similar product who
  have joined together in an agreement to act as a
  monopoly restrict output and raise price
• Normally cartels involve several firms
• Make retaliation against a dissenter difficult
• Agreements are not legally enforceable and are
  hence inherently unstable

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Reasons for collusion among firms

• To reduce the uncertainty of a noncooperative
  situation competition over market share makes
  firms unsure of what to do with regard to pricing
  decisions theyre afraid to change prices so
  to avoid the possibility of a price war, firms
  might try to cooperate.
• To increase profits this need for profit can
  turn out to be the downfall of most cartels
  GREED

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Collusion

• Overt collusion is illegal in the US.
• Most cartels fail. This is because 3 things are
  needed for a cartel to be successful, and theyre
  tough to accomplish
• 1st, the firms must come to an agreement as to
  what the price and quantity should be tough to
  do because different firms will have different
  cost structures and different assessments of
  market demand, so what is the profit-maximizing
  price and quantity for one firm is not likely to
  be the profit-maximizing combination for another
  firm.
• 2nd, the cartel members must adhere to the agreed
  upon price and production levels no cheating.
  But each firm knows that if it cheats and the
  others do not, that they can have higher profits.
  
• 3rd, there must be the potential for monopoly
  power the market demand curve must be
  relatively inelastic so that there are potential
  gains from increasing price it has to be a good
  with few substitutes.

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Is the NCAA a cartel?

• Where do the big profits come from at large state
  schools?
• sports
• Is it a competitive market?
• many schools but the large profits suggest that
  there is some monopoly power.
• The NCAA creates this market power and profit by
  restricting output limit the number of games
  per season, limit the number of teams per
  division, strict eligibility guidelines for
  schools
• Up until 1984 the NCAA restricted the number of
  games on TV and charged very high prices compared
  to today but the supreme court called it
  illegal collusion and as a result we have much
  more games on TV today than 20 years ago.
• Can we say the same things can be said for
  professional sports?

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Example collusion

• 2 firms sell bottled water with MC 0
• The firms agree to act as a monopolist and set
  price in order to maximize joint profits (P).
• Each will produce ½ of the output.
• No enforcement mechanism.
• Cheating by 1 firm selling the water at lt P gt
  that firm gains entire market.

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The Market Demand for Mineral WaterQ 1000, P
1.00 gt profits 500 each
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Temptation to Violate the Cartel Agreementif 1
firm cheats gt profits 990 0
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Practice

• Create the payoff matrix for this game
• Firms 1 2
• Options collude (price 1.00) or cheat (price
  0.90)
• Is there a dominant strategy for each firm?
• Is there an incentive to cut prices even more?

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Exam 2

• Thursday August 4, 600-900
• Same format as exam 1
• 25 short answer
• 2 essays (with options)