Competitive Markets

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Competitive Markets

• Dr. Yi LU
• February, 2008

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Introductory Story Global Oil Tanker Industry
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Introductory Story Global Oil Tanker Industry

• Players
• Integrated oil producers BP, Exxon, and Saudi
  Aramco, one-third
• Independent operators Frontline Ltd, Worldwide
  Shipping, two-third
• Markets fragmented in 2004
• Total tonnage 305 million ton
• Frontline largest with 15.1 million capacity and
  35 very large crude carries (VLCCs)
• Worldwide Shipping 7.26 million and 25 VLCCs

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Introductory Story Global Oil Tanker Industry

• Regulation
• Disasters caused the international and national
  authorities to impose more stringent standards on
  tanker safety.
• Demand
• Between 2002 and 2003, OPEC (Organization of
  Petroleum Exporting Countries) increased average
  daily production
• Former Soviet Union followed.
• Transport distances expected to fall.

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Introductory Story Global Oil Tanker Industry

• Cost
• Fuel accounts for one-third of tanker operation
  costs.
• Fuel consumption of VLCCs fell from 200 tons per
  day by over two-thirds in ten years
• Price of oil rose from 20.36 to 31.79 per
  barrel between 2002 and 2003.
• Questions
• How these changes affected the market for tanker
  services

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Sketch

• perfect competition
• market equilibrium
• supply shift
• demand shift
• applications
• adjustment time
• calculating equilibrium changes

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Perfect Competition

• Definition
• homogenous product
• many buyers
• many sellers
• free entry and exit
• equal information

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Perfect Competition Homogenous good

• Example
• Gold homogenous commodity
• Gold mined in North American is the same to that
  mined in Australia, Brazil, South Africa, etc.
• Pure substitutes
• Mineral water heterogeneous commodity
• Water from different sources has a different
  chemical composition, and thus different taste
  and therapeutic effect
• Nongfu Spring a little sweet from Qian Dao Hu
• Less substitutive and less competitive

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Perfect Competition Many buyers and sellers

• Buyers has little influence on determining the
  market price and face the same price.
• e.g. market for cotton
• Countless buyers, from Indian villagers to Paris
  designers
• Very small relative to the world supply
• Buyers with market power
• Negotiate a lower price
• Wal-Mart and its suppliers
• Different buyers pay different prices
• Not possible to construct a market demand curve

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Perfect Competition Free entry and exit

• No technological, legal, or regulatory barriers
  to entry and exit.
• Free entry
• if market price average cost, competitors will
  enter, increase supply, and depress price
• Free exit
• if market price enter, reduce supply, and raise price

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Perfect Competition Equal information

• Equal information about the market conditions
• Price
• Available substitutes
• Technology
• if one get lower price, others can get the same
  price.
• e.g., Photocopying service
• Market with differences in information not as
  competitive as one where all buyers and sellers
  have equal information.
• e.g. medical services

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Perfect Competition China Backs Draft Antitrust
Law

• What the antitrust law does give the governments
  power to address many market failures
• Mergers and acquisitions
• Collusion and price-fixing
• Predatory pricing etc
• On June 2006, Chinas cabinet, the State Council,
  gave approval in principle to a draft of the
  so-called Anti-monopoly law
• Ensure the countrys markets remain competitive

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Market Equilibrium

• Definition
• The price at which the quantity demanded equals
  the quantity supplied.
• When market out of equilibrium, market forces
  push price towards equilibrium

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Market equilibrium
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Market equilibrium Excess supply/demand

• excess supply excess of quantity supplied over
  quantity demanded
• triggers price decrease
• e.g., agricultural surpluses -- prices fall
• excess demand excess of quantity demanded over
  quantity supplied
• triggers price increase
• e.g., gasoline shortages -- increase in gasoline
  prices
• e.g., labor shortages -- wages rise

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Market equilibrium Significance

• Invisible hand drives market toward equilibrium
• Can be applied to consider impact of changes on
  the market equilibrium
• market conditions
• Price of the related product
• Cost of inputs
• government policy

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Supply shift

• External environment may cause the shift of the
  supply curve
• Price of the related products
• Cost of input
• Government regulation.
• Supply shifts down (right) ? lower price, larger
  quantity
• Supply shifts up (left) ? higher price, smaller
  quantity
• Final equilibrium depends on price elasticities
  of demand and supply

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Supply shift
new supply
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Supply shift Price elasticities of demand
original supply
new supply
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Supply shift Price elasticities of supply
new supply
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Supply Shift Price impact

• price change no more than amount of the supply
  shift
• price change
• smaller if demand is more elastic than supply
• larger if supply is more elastic than demand

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Supply shift Foie gras vis-à-vis butter

• Frances agricultural exports include foie gras
  and butter.
• The supply depends on the exchange rate between
  euro and other currencies.
• If Euro becomes 10 more expensive, compare
  effect on prices
• foie gras
• French butter

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Supply shift Promoting retailing sales

• Manufacturers When we reduce wholesale prices,
  retailers do not pass on the entire price cut.
• What causes this problem?

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Supply shift Promoting retail sales
after wholesale price cut
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Demand shift

• demand shifts down (right) ? lower price, lower
  quantity
• demand shifts up (left) ? higher price, larger
  quantity
• final equilibrium depends on price elasticities
  of demand and supply

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Demand shift
new demand
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Demand shift Price elasticities

• Exercise work out various scenarios
• completely elastic supply
• completely inelastic supply
• completely elastic demand
• completely inelastic demand

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Demand shift Valentines Day

• Demand for greeting cards and roses increase
  when Valentines day comes.
• Nearing Valentines Day, price of roses always
  rises much more than the price of greeting cards.
  Why?

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Demand and supply shifts Global Oil Tanker
Industry, 2002-03

• More stringent regulation of tanker safety ?
  reduction in supply
• OPEC and former Soviet Union increased production
  ? increase in demand
• Improving tanker fuel efficiency ? increase in
  supply
• Higher oil price ? reduction in supply

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Demand and supply shifts Seller and market
equilibrium
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Application--Pricing and Freight Cost

• Cost and freight (CF) price
• Including the cost of delivery to the buyer
• Ex-works pricing
• Not include the freight cost, the cost of
  delivery to the buyer
• How does pricing policy affect sales?

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Application--Pricing and Freight Cost
CF supply
25 cents
25 cents
ex-works supply
a
1.50
Price ( per pound)
b
CF demand
ex-works demand
1
0
Quantity (Million pounds a year)
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Applications--Retailing Why coupons?

• Some suggest that coupons are more effective in
  lowering retail prices than cuts in wholesale
  prices
• With coupons, prevent retailers from getting
  part of price cut.
• Questions are coupons more effective than direct
  cuts in wholesale prices?

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Applications--Retailing Why coupons?
Original supply
25 cents
25 cents
Supply with wholesale price cut
v
u
p
s
Price ( per bottle)
4.00
3.80
t
Demand with coupon
w
Original demand
550
500
0
Quantity (Million bottles a year)
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Application--Tax

• the only two sure things in life are death and
  taxes
• buyers price tax sellers price
• payment vis-à-vis incidence
• US airlines pay tax
• Asia passengers pay
• What is the difference

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ApplicationTax surplus
buyer surplus loss fdge egb seller surplus
loss djhg ghb revenue gain fdge djhg
10
804
f
e
supply
Price ( per ticket)
800
b
d
g
794
demand
h
j
0
900
920
Quantity (Thousand tickets a year)
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Adjustment time

• Elasticities of demand and supply vary with time
  horizon
• short run demand supply ? short run equilibrium
• long run demand supply ? long run equilibrium

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Adjustment time Short run equilibrium
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Adjustment time Long run equilibrium
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Adjustment time Short/long-run impact

• If demand/supply shifts,
• market price is more volatile in the short run
  than long run
• greater change in market quantity over the long
  run than short run

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Adjustment time Short/long-run impact
Short-run supply
new demand
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Calculating equilibrium changes

• calculate change in quantity demanded
• calculate change in quantity supplied
• equate changes and solve for change in price
• calculate change in quantity

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Calculating equilibrium changes

• How would 3 increase in income affect price and
  sales of gasoline?
• demand
• price elasticity -0.23
• income elasticity 0.39
• supply
• price elasticity 0.62

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Calculating equilibrium changes

• change in qty demanded -0.23 p 0.39 x 3
• change in qty supplied 0.62 p
• equate and solve p 1.38
• change in qty 0.85