TopicChapter 5 Market structure and imperfect competition

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Topic/Chapter 5Market structure and imperfect
competition
Business EconomicsFor School of Management
StudentsSpring Semester 2008
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Topic/Chapter 5Market structure and imperfect
competition

• Will cover
• 5.1 Pure Monopoly
• 5.2 Imperfect competition and market structure

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5.1 Pure MonopolyLearning outcomes

• By the end of this section, you should
  understand
• How a monopolist chooses output
• How this output compares with that in a
  competitive industry
• How a monopolists ability to price discriminate
  affects output and profits

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Monopoly

• A monopolist
• is the sole supplier of an industrys product
• and the only potential supplier
• is protected by some form of barrier to entry
• faces the market demand curve directly
• Unlike under perfect competition, MR is always
  below AR
• i.e. MR is below the demand curve.
• Monopoly power is measured by price minus
  marginal cost
• P-MC

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Profit Maximization by a Monopolist
Profits are maximized where MC MR at Q1P1.
In this position, AR is greater than AC so the
firm makes profits above the opportunity cost
of capital
A
Entry barriers prevent new firms joining
the industry.
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Comparing Monopoly with Perfect Competition

• Monopoly compared with perfect competition
  implies
• higher price

• lower output

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Comparing Monopoly with Perfect Competition
(continued)

• Does the consumer always lose from monopoly?
• Among other things, this depends on whether the
  monopolist faces the same cost structure
• Arguably the monopolist has an incentive to
  undertake RD in order to improve technology and
  reduce costs
• i.e. To make greater, permanent long run profits
• Whereas a competitive firm only makes temporary
  economic profits so the incentive is less.
• Argued by some that if you take a dynamic longer
  term perspective monopolists might result in
  lower prices and greater output.

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Patents

• Most Western economies operate a patent system
• Inventors of new processes acquire a temporary
  legal monopoly for a fixed period
• By temporarily excluding entry and imitation, the
  patent laws increase the incentive to conduct RD
  without establishing a monopoly in the long run
• Over the patent life the inventor gets a higher
  price and makes profits
• Eventually the patent expires and competition
  from other firms leads to higher output and lower
  prices

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Discriminating Monopoly

• Suppose a monopolist supplies two separate groups
  of customers
• with differing elasticities of demand
• e.g. business travellers may be less sensitive to
  air fare levels than tourists
• The monopolist may increase profits by charging
  higher prices to the businessmen than to
  tourists.
• Discrimination is more likely to be possible for
  goods that cannot be resold
• e.g. dental treatment

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Perfect Price Discrimination

• A monopolist will charge price P1
• under perfect price discrimination each customer
  pays what its worth to them
• the highest bidder pays E and the next highest
  bidder a little less and so on
• So perfectly price discriminating monopolist
  produces at C where MCDD (which is now MR)

Price
E
MC
A
P1
C
B
DD
MR
Output
Q1
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5.2 Imperfect competition and market structure
Learning outcomes

• By the end of this section, you should
  understand
• Imperfect competition and market power
• How differences in cost and demand affect market
  structure
• Monopolistic competition
• The tension between collusion and competition
  within a cartel
• Oligopoly and interdependence
• Games
• Commitment and credibility
• Why there is little market power in a contestable
  market
• Innocent entry barriers and strategic entry
  barriers

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The Range of Market Structure

• Perfect competition and monopoly are extreme
  forms of market structure
• firms operating between these extremes facing
  imperfect competition
• two examples of imperfect competition are
• oligopoly, and
• monopolistic competition

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Most markets fall between the two extremes of
monopoly and perfect competition

• An imperfectly competitive firm
• would like to sell more at the going price
• faces a downward-sloping demand curve
• recognises its output price depends on the
  quantity of goods produced and sold

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Imperfect Competition

• An oligopoly
• an industry with a few producers
• each recognizing that its own price depends both
  on its own actions and those of its rivals.
• In an industry with monopolistic competition
• there are many sellers producing products that
  are close substitutes for one another
• each firm has only limited ability to influence
  its output price.

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Market Structure
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Why Market Structures Differ

• Minimum efficient scale MES of operation of a
  firm is the lowest output at which its LAC
  bottoms out
• when MES is small in an industry there is room
  for many firms
• when MES is relative large compared to the entire
  market there is only room for a few firms
• when MES is as large as the entire market there
  is only room for one firm
• A natural monopoly enjoys sufficient scale
  economies to have no fear of entry by others.

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Monopolistic Competition

• Characteristics
• many firms
• no barriers to entry
• product differentiation
• so the firm faces a downward-sloping demand curve
• Few economies of scale.
• The absence of entry barriers means that profits
  are competed away

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Long Run Equilibrium inMonopolistic Competition
Price, cost

• Price LAC
• each firms demand curve is tangent to the LAC
• No economic profits in the long run

LMC
LAC
P
DD
MR
Output
q
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Oligopoly

• A market with a few sellers
• The essence of an oligopolistic industry is the
  need for each firm to consider how its own
  actions affect the decisions of its relatively
  few competitors.
• Oligopoly may be characterized by collusion or by
  non-co-operation

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Collusion and Cartels

• COLLUSION
• an explicit or implicit agreement between
  existing firms to avoid or limit competition with
  one another
• CARTEL
• is a situation in which formal agreements between
  firms are legally permitted
• e.g. OPEC

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The Kinked Demand Curve - 1
Consider how a firm may perceive its demand
curve under oligopoly.
It can observe the current price and output,
but must try to anticipate rival reactions to
any price change.
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The Kinked Demand Curve - 2
The firm may expect rivals to respond if it
reduces its price, as this will be seen as an
aggressive move
so demand in response to a price reduction is
likely to be relatively inelastic
The demand curve will be steep below P0.
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The Kinked Demand Curve - 3
but for a price increase rivals are less likely
to react,
so demand may be relatively elastic above P0
so the firm perceives that it faces a
kinked demand curve.
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The Kinked Demand Curve - 4
Given this perception, the firm sees that revenue
will fall whether price is increased or decreased,
so the best strategy is to keep price at P0.
MC2
Price will tend to be stable, even in the face of
an increase in marginal cost.
MC3
MR
MC1
Or a decrease in marginal cost.
MR
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The Kinked Demand Curve - 5Summary

• An oligopolist who increases price will not be
  matched by competitors
• An oligopolist who reduces price will be matched
  by competitors
• the kink means that MC can change without
  affecting price

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Game Theory Some Key Terms

• Game
• a situation in which intelligent decisions are
  necessarily interdependent
• Strategy
• a game plan describing how the player will act or
  move in every conceivable situation
• Dominant strategy
• where a players best strategy is independent of
  those chosen by others
• Nash Equilibrium
• where each player chooses the best strategy,
  given the strategies chosen by other players

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The Prisoners Dilemma Game
Consider two firms in a duopoly each with a
choice of producing high or low output
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The Prisoners Dilemma

• Each firm has a dominant strategy to produce high
• so they make 1 unit profit each
• but they would both be better off producing low
• as long as they can be sure that the other firm
  also produces low.
• So collusion can bring mutual benefits
• But there is incentive for each firm to cheat
• Illustrates the tension between collusion and
  competition

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Competition vs. Collusion

• Each firm must decide whether to co-operate or
  compete
• cartels survive when members enter into binding
  commitments
• A commitment is an arrangement, entered into
  voluntarily, that restricts ones future actions
• to maintain agreements there must be a credible
  threat of punishment for cheaters
• A credible threat is one that, after the fact, it
  is still optimal to carry out

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Entry and Potential Competition

• So far we have focussed upon imperfect
  competition between existing firms
• But potential competition from new entrants is
  also important
• Look at three cases
• Where entry is easy
• (Contestable markets)
• Where entry is difficult and
• (Innocent entry barriers)
• Where entry is difficult by design.
• (Strategic Entry deterrence)

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Contestable Markets

• A contestable market is characterized by free
  entry and free exit
• no sunk costs
• allows hit-and-run entry
• Contestability may constrain incumbent firms from
  exploiting their market power.

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Innocent Entry Barriers

• An innocent entry barrier is one made by nature
• Absolute cost advantages, where incumbent firms
  have lower cost curves than entrants may be
  innocent
• If it takes time to learn the business,
  incumbents have lower costs in the short run.
• Scale economies are another innocent entry
  barrier
• i.e. Where MES is large relative to market size

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Strategic Entry Deterrence

• Strategic entry deterrence is behaviour by
  incumbent firms to make entry less likely
• i.e .some entry barriers are deliberately erected
  by incumbent firms
• threat of predatory pricing
• spare capacity
• advertising and RD
• product proliferation
• Actions that effectively enforce sunk costs on
  potential entrants