Market Conduct Outline of Discussion

1
Market ConductOutline of Discussion

• Primary Source Chapters Three and Four of the
  Richard Caves Text
• Topics to be Discussed
• Setting Prices
• Cooperative Models
• Non-Cooperative Models
• Non-Price Policies
• Product Differentiation and Advertising
• Entry Deterrence
• Diversification

2
Non-Oligopoly Models

• Perfect Competition
• Short-Run P MR MC
• Long-Run P MR MC ATC
• Monopolistic Competition
• Short-Run P gt MR MR MC
• Long-Run P gt MR P ATC MR MC
• Monopoly
• P gt MR MR MC
• NOTES Short-run and long-run are defined by
  entry and exit of firms. Hence, for monopoly, we
  do not make such a distinction.
• PUNCHLINE There is no interaction between firms,
  so the decision-making process for firms in these
  market structures is relatively simple.

3
Conjectural Variation

• In perfect competition, monopoly, monopolistic
  competition, firm i is not concerned about the
  actions of firm j (where i is not equal to j).
• In oligopoly ?Qi/ ?Qj is not equal to zero.
• The actual value of this derivative would be
  speculative, hence firm i must make conjectures
  regarding the decision-making of firm j.

4
OligopolySetting Prices

• Cooperative Models
• Cartels
• Tacit Coordination
• Price Leadership Model
• Non-Cooperative Models
• Kinked Demand Curve Model
• Cournot Duopoly
• Stackelberg Duopoly
• Bertrand Duopoly

5
Cartels, in general

• Joint Profit Maximization Charge the same price
  and earn the same profit as a monopolist. This
  profit is then divided among the firms.
• General problems with joint agreements
• No agreement on principle
• No agreement on details
• No adherence to an agreement
• THE STANDARD CARTEL MODEL

6
Cartels, necessary conditions

• Inelastic Industry Demand
• If industry demand is elastic, what will happen
  to profits when price is increased?
• Low expectations of severe punishment
• Low organizational costs
• Number of firms in the cartel
• Concentration of the industry
• Homogenous good

7
Cartels, enforcing the agreement

• NOTE If firms want to cheat, the most ideal
  environment will destroy the cartel.
• Cheating, though, is less likely when
• there are few firms in the industry.
• prices do not fluctuate independently output
  demand and input supply conditions are relatively
  stable.
• prices are widely known.
• all members produce the same product at the same
  point in the distribution chain. (i.e. face the
  same type of customer)
• Vertical marginal cost curves limit the desire to
  cheat, horizontal marginal cost curves increase
  incentives.
• Large number of small customers vs. Small number
  of large customers In the latter case, cheating
  is much more likely. In the former case,
  cheating is only possible if a large number of
  customers know your price is lower.

8
Tacit Coordination

• This is a model that once applied nicely to the
  domestic automobile market.
• Model changes in the market occur at predictable
  times. Furthermore, all firms know how prices
  are determined when cost and demand conditions
  change.
• Consequently, firms can set prices at
  near-monopoly levels and know the competition
  will follow.
• NOTE International competition tends to disrupt
  such coordination.

9
Oligopoly Models

• Cooperative Price Leadership or Dominant Firm
  Model
• Non-Cooperative
• Kinked Demand Curve (in Caves)
• Cournot Model (not in Caves, refer to notes)
• Stackelberg (not in Caves, refer to notes)
• Bertrand Duopoly (not in Caves)
• ALL OF THESE MODELS ARE BASED UPON PREDICTABLE
  REACTIONS FROM COMPETITORS.

10
Kinked Demand Curve

• See Figure 4-1 on page 54
• Premise of the model Firms follow a price
  decrease, but do not follow a price increase.
• Hence the elasticity of demand will differ
  depending upon the decision the firm makes.
• Implication Firms have an incentive not to
  change price, even if costs change.

11
Bertrand Duopoly

• Assumptions
• Two Firm
• Identical Products
• Constant MC (to simplify presentation)
• Perfect Information
• Zero Transaction Costs
• Unlike the Cournot and Stackelberg models, firms
  compete on price, not quantity.
• Equilibrium in the model P MC
• Lessons from the Bertrand Duopoly
• Product differentiation matters
• Firms do not wish to compete on price.

12
Non-Price Market Conduct

• As the Bertrand Duopoly demonstrates, firms do
  not wish to compete on price. A more effective
  method is to engage in non-price competition.
• We shall discuss
• Advertising
• Entry Deterrence
• Diversification of the Firm

13
Advertising

• Benefits of Advertising
• inelastic demand will allow higher prices
• protection against competitors price and
  advertising decisions
• A firm should increase advertising up to the
  point where the marginal benefits of advertising
  equal the marginal costs.
• If advertising is a zero-sum game (i.e.
  advertising only is useful as a defense against
  others advertising) society faces a loss of
  social resources.

14
Entry Deterrence

• Limit Pricing (previously discussed)
• Tying contracts
• Maintain excess capacity
• Seeking patents
• Introduce new products to fill market niches
• Avoid disclosing profit data

15
Diversification

• NOTE Caves discusses this issue in Chapter
  Three.
• Diversification investment in multiple
  projects.
• Vertical Integration
• Horizontal Integration
• Conglomerate Integration

16
Vertical Integration

• Vertical integration - various stages of
  production of a single product are conducted by a
  single firm.
• Motivation Reduces Transaction Costs
• Transaction costs - the expenses of trading with
  others above and beyond the price. i.e. the cost
  of writing and enforcing contracts.
• Transaction costs determine whether markets are
  internalized or allowed to remain external to the
  firm.

17
More on Transaction Costs The Work of Oliver
Williamson

• Four basic concepts that underlie transaction
  costs analysis.
• Markets and firms are alternative means for
  completing related sets of transactions.
• The relative cost of using markets or a firms
  own resources should determine the choice.
• The transaction cost of writing and executing
  contracts across a market is a function of
• the characteristics of the involved human actors
• the objective properties of the market
• In sum, both human and environmental factors
  impact the transaction costs across firms and
  markets.
• Purpose of this analysis is to identify the set
  of environmental and human factors that explain
  both internal firm and industrial organization.
• Key environmental factors Uncertainty and number
  of firms
• Key human factors Bounded rationality and
  opportunism

18
Bounded Rationality and Opportunism

• Bounded rationality - the limited human capacity
  to anticipate and solve complex problems.
• Opportunistic behavior - Taking advantage of
  another when allowed by circumstances.
• High transaction costs
• Specialized products The creation of specialized
  products, where only a single buyer and/or seller
  exists, can lead to opportunistic behavior. This
  provides an incentive for vertical integration.
• Changing market conditions Bounded rationality
  and uncertain market conditions make the writing
  and enforcement of contracts involving future
  conditions undesirable for both parties. Such
  high transaction costs increases the likelihood
  of vertical integration.

19
Market vs. Internal Production

• Labor theory Wages Marginal Revenue Product
• Marginal Revenue Product Marginal Revenue of
  Output (MR) Marginal Product of Labor (MP)
• However, for this to be true for each worker a
  firm would need to measure MP.
• What if a firm cannot measure MP? Then a worker
  can reduce effort an still maintain the same
  wage. (WILL DISCUSS W.R.T. GAME THEORY)
• When monitoring costs are high, a firm has an
  incentive to sub-contract work.
• Why? For independent workers the wage (profit) is
  closer linked to productivity.

20
Final Points on Vertical Integration

• In addition to transaction costs, vertical
  integration is also motivated by two additional
  considerations.
• Vertical integration provides assurance of
  supplying inputs/outputs in a market that may be
  unstable.
• Threatens potential entrants by raising entry
  barriers (aluminum example)

21
Horizontal Integration

• Horizontal integration - merging of the
  production of similar products into a single
  firm.
• Motivation
• Economies of Scale
• Increased Market Share

22
Conglomerate Integration

• Conglomerate - integration of different products
  into a single firm.
• Motivation Reduces the risk of a business due
  to changes in the macro-economy.

23
Final Notes on Diversification

• Impact of Diversification on Market Structure.
• Cross-subsidization Profits from one market used
  to subsidize activity in another market.
• Concealment of performance through consolidated
  financial statements.