Unit IV: Imperfect Competition

1
Unit IV Imperfect Competition
2
Characteristics of Monopolies
3
5 Characteristics of a Monopoly
1. Single Seller

• One Firm controls the vast majority of a market

• The Firm IS the Industry

2. Unique good with no close substitutes
3. Price Maker

• The firm can change the price by changing the
  quantity it produces (ie. shifting the supply
  curve to the left).

4
5 Characteristics of a Monopoly
4. High Barriers to Entry

• New firms CANNOT enter market

• No immediate competitors

5. Some Nonprice Competition

• Despite having no close competitors, monopolies
  still advertise their products in an effort to
  increase demand.

5
Examples of Monopolies
6
Four Origins of Monopolies
1. Geographical Monopolies Ex Nowhere gas
stations, De Beers Diamonds, San Diego Chargers,
Cable TV, Qualcomm Hot Dogs -Location or
control of resources limits competition and
leads to one supplier. 2. Government
Monopolies Ex Water Company, Firefighters, The
Army, Pharmaceutical drugs, rubix cubes
-Government allows monopoly for public benefits
or to stimulate ingenuity. -The government
issues patents to protect inventors and forbids
others from using their invention. (They last 20
years)
7
Four Origins of Monopolies

• 3. Technological Monopolies
• Ex Microsoft, Intel, Frisbee, Band-Aide
• -Patents and widespread availability of certain
  products lead to only one major firm controlling
  a market.
• 4. Natural Monopolies
• Ex Electric Companies (SDGE)
• If there were three competing electric companies
  they would have higher costs.
• Having only one electric company keeps prices low
• -Economies of scale make it impractical to have
  smaller firms.
• -Low average total costs act as a barrier to
  entry for other firms.

8
Electric companies have economies of scale. The
more they produce the lower the average cost.
Assume that 200 units need to be produced
20
15
LRATC
Average Total Cost
10

• If there are 4 firms, the ATC is 20
• If there are 2 firms the ATC is 15
• If there is 1 firm the ATC is 10

0
50
100
200
Quantity
9
Drawing Monopolies
10

• Good news
• Only one graph because the firm IS the industry.
• The cost curves are the same
• The MR MC rule still applies
• Shut down rule still applies
• Unlike perfect competition, all imperfectly
  competitive firms have downward sloping demand
  curve.
• To sell more a firm must lower its price.

11
Combine the Demand of an industry with the costs
of a firm.
MC
ATC
What about MR?
Costs (dollars)
D
Quantity
12
To sell more a firm must lower its price. What
happens to Marginal Revenue?
Price Quantity Demanded Total Revenue Marginal Revenue
6 0
5 1
4 2
3 3
2 4
1 5
Does the Marginal Revenue equal the price?
13
To sell more a firm must lower its price. What
happens to Marginal Revenue?
Price Quantity Demanded Total Revenue Marginal Revenue
6 0 0
5 1 5
4 2 8
3 3 9
2 4 8
1 5 5
Does the Marginal Revenue equal the price?
14
To sell more a firm must lower its price. What
happens to Marginal Revenue?
Price Quantity Demanded Total Revenue Marginal Revenue
6 0 0 -
5 1 5 5
4 2 8 3
3 3 9 1
2 4 8 -1
1 5 5 -3
MR DOESNT EQUAL PRICE
Plot Demand and Marginal Revenue Curves
15
Plot Demand and Marginal Revenue Curves
Quantity Price TR MR
0 16 0 -
1 15 15 15
2 14 28 13
3 13 39 11
4 12 48 9
5 11 55 7
6 10 60 5
7 9 63 3
8 8 64 1
9 7 63 -1
10 6 60 -3
16
Plot Demand and Marginal Revenue Curves
Quantity Price TR MR
0 16 0 -
1 15 15 15
2 14 28 13
3 13 39 11
4 12 48 9
5 11 55 7
6 10 60 5
7 9 63 3
8 8 64 1
9 7 63 -1
10 6 60 -3
17
Why is MR below Demand?
P
As price decreases from 100 to 90...
revenue will increase with
the additional unit sold.
100 90 60 40
TR300
D
TR 360
Q
1 2 3 4 5 6
18
Why is MR below Demand?
P
But a lower price results in a loss of the 30
that was earned when price was 10 higher
100 90 60 40
Loss 30
TR300
D
TR 360
Gain 90
Q
1 2 3 4 5 6
19
Why is MR below Demand?
P
Marginal Revenue is ADDITIONAL REVENUE MR
(Price Loss from lowering price) MR 90 - 30
60
100 90 60 40
Loss 30
TR300
D
TR 360
Gain 90
Q
1 2 3 4 5 6
20
Why is MR below Demand?
P
As price decreases from 90 to 80 TR increases
MR
80 40 40
100 90 80 60 40
Loss 40
D
Gain 80
Q
1 2 3 4 5 6
21
Why is MR below Demand?
P
100 90 80 60 40
D
MR
Q
1 2 3 4 5 6
22
Why is MR below Demand?
P
100 90 80 60 40
MR CURVE IS LESS THAN DEMAND CURVE!!!
D
MR
Q
1 2 3 4 5 6
23
Elastic vs. Inelastic Range of Demand Curve
24
Elastic and Inelastic Range
200 150 100 50
Dollars
Q
0 1 2 3 4 5 6 7 8 9 10 11 12
13 14 15 16 17 18
750 500 250
Dollars
Q
0 1 2 3 4 5 6 7 8 9 10 11 12
13 14 15 16 17 18
25
Elastic and Inelastic Range
Elastic
200 150 100 50
Total Revenue Test If price falls and TR
increases then demand is elastic.
Dollars
MR
D
Q
0 1 2 3 4 5 6 7 8 9 10 11 12
13 14 15 16 17 18
750 500 250
Dollars
TR
Q
0 1 2 3 4 5 6 7 8 9 10 11 12
13 14 15 16 17 18
26
Elastic and Inelastic Range
Inelastic
Elastic
200 150 100 50
Total Revenue Test If price falls and TR
increases then demand is elastic.
Dollars
MR
D
Q
Total Revenue Test If price falls and TR falls
then demand is inelastic.
0 1 2 3 4 5 6 7 8 9 10 11 12
13 14 15 16 17 18
750 500 250
When MR goes negative, TR will fall
Dollars
TR
Q
0 1 2 3 4 5 6 7 8 9 10 11 12
13 14 15 16 17 18
27
Putting Demand, MR, and Cost Together
28
What output should this monopoly produce?
MR MC
How much is the TR, TC and Profit or Loss?
9 8 7 6 5 4 3 2
MC
ATC
Profit 5
D
MR
29
Conclusion A monopolists produces where MRMC,
buts charges the price consumer are willing to
pay identified by the demand curve.
9 8 7 6 5 4 3 2
MC
ATC
D
MR
30
What if cost are higher?
How much is the TR, TC, and Profit or Loss?
MC
ATC
140
Loss
AVC
D
Minimum AVC is shut down point
MR
Q
31
TR TC Profit/Loss Profit/Loss per Unit
780
Identify and Calculate
600
180
30
MC
130
ATC
110
D
MR
32
Are Monopolies Efficient?
33

• Monopolies are inefficient because they
• Charge a higher price
• Under produce
• Not allocativly efficiency
• Produce at higher costs
• No productive efficiency
• Have little incentive to innovate

Why? Because there is little external pressure to
be efficient
34
INEFFICIENCY OF PURE MONOPOLY
P
S MC
CS
Pc
PS
D
Q
Qc
35
INEFFICIENCY OF PURE MONOPOLY
P
S MC
At MRMC A monopolist will sell less units at a
higher price than in competition
Pm
Pc
D
MR
Q
Qc
Qm
36
CS and PS of a Monopoly
P
Result is DEADWEIGHT LOSS to society
S MC
CS
Pm
Pc
PS
D
MR
Q
Qc
Qm
37
CS and PS of a Monopoly
P
Result is DEADWEIGHT LOSS to society
S MC
CS
Pm
Pc
PS
Monopoly pricing causes consumers to overpay so
CS becomes PS
D
MR
Q
Qc
Qm
38
Are Monopolies Productively Efficient?
No. They are not producing at the lowest cost
(min ATC)
Does Price Min ATC?
MC
ATC
D
MR
39
Do Monopolies Have Allocative Efficiency?
No. Price is greater. The monopoly is under
producing.
Does Price MC?
MC
ATC
D
MR
40
Regulating Monopolies
41
Why Regulate?

• Why would the government regulate an monopoly?
• To keep prices low
• To make monopolies efficient

How do they regulate?

• Use Price controls Price Ceilings
• Why dont taxes work?
• Taxes limit supply-thats the problem

42
Where should the government place the price
ceiling?
1.Socially Optimal Price P MC (Allocative
Efficiency)
OR
2. Fair-Return Price (BreakEven) P ATC (Normal
Profit)
43
REGULATED NATURAL MONOPOLY
Monopoly Price MR MC
P
Pm
Price and Costs
ATC
MC
D
MR
Q
Qm
44
REGULATED NATURAL MONOPOLY
P
Fair-Return Price Normal Profit Only
TR TC
Price and Costs
ATC
Pf
MC
D
MR
Q
Qf
45
REGULATED NATURAL MONOPOLY
P
Socially-Optimum Price P MC
Price and Costs
ATC
MC
Pr
D
MR
Q
Qr
46
REGULATED NATURAL MONOPOLY
Dilemma of Regulation Which Price?
P
MR MC
Fair-Return Price
Pm
Socially-Optimum Price
Price and Costs
ATC
Pf
MC
Pr
D
MR
Q
Qm
Qf
Qr
47
Price Discrimination
48
PRICE DISCRIMINATION
Definition Practice of selling the same products
to different buyers at different prices
Requires the following conditions

• Firm must have monopoly power
• Firm must be able to segregate the market
• Consumers must not be able to resell product

49
PRICE DISCRIMINATION

• Price discrimination seeks to charge each
  consumer what they are willing to pay in an
  effort to increase profits.

• Those with inelastic demand are charged more than
  those with elastic

Examples

• Airline Tickets (vacation vs. business)
• Movie Theaters (child vs. adult)
• All Coupons (spenders vs. savers)
• SPHS soda machine (students vs. teachers)

50
PRICE DISCRIMINATION
MC
Economic profits with a single MRMC price
P
ATC
Price and Costs
D
MR
Q
Q1
51
A perfectly discriminating can charge each person
differently so the Marginal Revenue Demand
MC
P
ATC
Price and Costs
MRD
D
Q
Q1
Q2
52
What output do they make? Where is Consumer
Surplus?
MC
P
ATC
Price and Costs
MRD
D
Q
Q2
53
Where is the Profit?
MC
Profit with price discrimination
P
ATC
Price and Costs
MRD
D
Q
Q1
Q2
54
Whats the Point?

• Perfectly price discriminating firms

• Make more profit
• Produce more
• Produce at allocative efficiency

55
Allocative Efficiency
MC
P
Price MC
ATC
Price and Costs
MRD
D
Q
Q1
Q2
56
Can You Do The Following?
1.Draw a monopoly making a profit at long-run
equilibrium and identify price, quantity, and
profit.
2. Draw a perfectly competitive industry AND firm
at long-run equilibrium
3. Draw a price discriminating monopoly at
equilibrium and label price, quantity, MR, and
profit
57
Monopolistic Competition
58
FOUR MARKET MODELS
Monopolistic Competition

• Relatively Large Number of Sellers
• Differentiated Products
• Some control over price
• Easy Entry and Exit
• Extensive non-price competition

59

• Examples
• Fast Food Restaurants
• Furniture companies
• Jewelry stores
• Hair Salons
• Clothing Manufacturers

60
Monopolistic Competition

• Monopolistic Qualities
• Control over price of own good due to
  differentiated product.
• D gt MR
• Plenty of non-price competition
• Not efficient

• Perfect Competition Qualities
• Large number of smaller firms
• Relatively easy entry and exit
• Zero Economic Profit in Long-Run since firms can
  enter.

61

• Differentiated Products
• Goods are NOT identical.
• Firms seek to capture a piece of the market by
  making unique goods.
• Since these products have substitutes, firms use
  NON-PRICE Competition
• Brand Names and Packaging
• Product Attributes
• Service
• Location
• Advertising (Two Goals)
• 1. Increase Demand
• 2. Make demand more INELASTIC

62
Drawing Monopolistic Competition
63
PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION
MC
What Happens?
ATC
4
2
Price and Costs
Short-Run Economic Profits
D
MR
Q1
Quantity
64
PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION
MC
New Firms Enter
ATC
In the long-run, new firms will enter, driving
down the DEMAND for firms already in the market.

4
2
Price and Costs
Short-Run Economic Profits
D
MR
Q1
Quantity
65
PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION
MC
What will happen?
ATC
4
2
Price and Costs
Short-Run Economic Profits
D
MR
Q1
Quantity
66
LONG- RUN EQUILIBRIUM
MC
ATC
Normal Profit
4
2
Price and Costs
1
D
MR
Q1
Quantity
67
Why does DEMAND shift?

• When short-run profits are made
• New firms enter
• New firms mean more close substitutes and less
  market shares for each existing firm.
• Demand for each firm falls
• When short-run losses are made
• Firms exit
• Result is less substitutes and more market shares
  for remaining firms.
• Demand for each firm rises

68
PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION
MC
What happens?
ATC
7
Price and Costs
1
Short-Run Economic Loss
With economic losses, firms will exit the market
stability occurs when economic profits are zero.
D
MR
Q1
Quantity
69
PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION
MC
What happens?
ATC
7
Price and Costs
1
Short-Run Economic Loss
D
MR
Q1
Quantity
70
PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION
MC
Long-Run Equilibrium
Normal Profit Only
ATC
7
Price and Costs
D
MR
Q3
Quantity
71
MONOPOLISTIC COMPETITIONAND EFFICIENCY
72
MONOPOLISTIC COMPETITION AND EFFICIENCY

• Not Productively Efficient
• ? Minimum ATC
• Not Allocatively Efficient
• Price ? MC
• Firm has Excess Capacity

Graphically
73
MONOPOLISTIC COMPETITION AND EFFICIENCY
MC
Long-Run Equilibrium
ATC
P3 A3
Price and Costs
D
MR
Q3
Quantity
74
MONOPOLISTIC COMPETITION AND EFFICIENCY
Excess Capacity

• The gap between the minimum ATC output and the
  profit maximizing output
• Given current resources, the firm can produce at
  minimum ATC, but they decide not to.

75
MONOPOLISTIC COMPETITION AND EFFICIENCY
MC
Long-Run Equilibrium
ATC
P3 A3
Excess Capacity
Price and Costs
D
MR
Q3
Quantity
76
Advantages of MONOPOLISTIC COMPETITION

• Large number of firms and product variation meets
  societies needs
• Nonprice Competition (product differentiation and
  advertising) may result in sustained profits for
  some firms.
• Ex Nike might continue to make above normal
  profit because they are a well known brand.

77
Oligopoly
78
FOUR MARKET MODELS
Oligopoly

• A Few Large Producers
• Identical or Differentiated Products
• Control Over Price, But Mutual Interdependence
• Firms use Strategic Pricing
• High Entry Barriers
• Examples OPEC, Cereal Companies, Car Producers

79
HOW DO OLIGOPOLIES OCCUR?

• Oligopolies occur when only a few large firms
  start to control an industry.
• High barriers to entry keep others from entering.
  
• Types of Barriers to Entry
• Economies of Scale
• High Start-up Costs
• Ownership of Raw Materials

80
Game Theory
81
What is game theory?

• The study of how people behave in strategic
  situations
• A thorough understanding of game theory helps
  firms in an oligopoly maximize profit.

82
Why learn about game theory?

• Oligopolies are interdependent since they compete
  with only a few other firms.
• Their pricing and output decisions must be
  strategic as to avoid economic losses.
• Game theory helps us analyze their strategies.
• SIMULATION!!!!!

83
The Prisoners Dilemma
Charged with a crime, each prisoner has one of
two choices Deny or Confess
Prisoner 2
Deny
Confess
Both Deny 3 Years in jail each
Confess 1 Year Deny 7 Years
Deny
Prisoner 1
Confess 1 Year Deny 7 Years
Both Confess 5 Years in jail each
Confess
84
Strategic Pricing
Each firm has one of two choices Price High or
Price Low.
Firm 2
High
Low
Both High 2 Each
Low 3 High 0
High
Firm 1
Low 3 High 0
Both Low 1 each
Low
85
OLIGOPOLY BEHAVIOR
A Game-Theory Overview
RareAirs Price Strategy
Uptowns Price Strategy
86
OLIGOPOLY BEHAVIOR
Greatest Combined Profit if both Sell High
RareAirs Price Strategy
Uptowns Price Strategy
87
OLIGOPOLY BEHAVIOR
Each firm recognizes that more profit is made if
they lower price
RareAirs Price Strategy
Uptowns Price Strategy
88
OLIGOPOLY BEHAVIOR
BUT if both lower price they end up in the Worst
Case
RareAirs Price Strategy
Uptowns Price Strategy
89
OLIGOPOLY BEHAVIOR
To make more profit, firms may try to cooperate
(collude)
RareAirs Price Strategy
Uptowns Price Strategy
90
OLIGOPOLY BEHAVIOR
To make more profit, firms may try to cooperate
(collude)
RareAirs Price Strategy
Uptowns Price Strategy
91
OLIGOPOLY BEHAVIOR
But now each firm has the incentive to cheat.
RareAirs Price Strategy
Uptowns Price Strategy
92
What did we learn?

• Oligopoly pricing must be strategic
• Oligopolies have a tendency to collude to gain
  profit.
• (Collusion is the act of cooperating with rivals
  in order to rig a situation.)
• Collusion results in the incentive to cheat.

93
Oligopoly Graphically
94
THREE OLIGOPOLY MODELS
Not one standard model due to...
Complications of Interdependence
Instead there are 3 Alternative Models
1 Price Leadership (no graph) 2 Cartels and
Collusion (known graph) 3 Kinked Demand Curve
(new graph)
95
Price Leadership
96
PRICE LEADERSHIP MODEL

• Collusion is ILLEGAL.
• Firms CANNOT set prices.
• Price leadership is a strategy used by firms to
  coordinate prices without outright collusion

• General Process
• Dominant firm initiates a price change
• Other firms follow the leader
• Example 3 competing gas stations.

97
PRICE LEADERSHIP MODEL

• Breakdowns in Price Leadership
• Temporary Price Wars may occur if other firms
  dont follow price increases of dominant firm.
• Each firm tries to undercut each other.
• Example Employee Pricing for Ford

98
Cartels and Collusion
99
CARTELS AND COLLUSION
Cartel Colluding Oligopoly
A cartel is a group of producers that create a
formal agreement to fix prices high. Examples
1. Overt Collusion- OPEC ( Organization of
Petroleum Exporting Countries) 11 countries set
limits on the supply of oil 2. Covert Collusion-
In 1998, Toys R Us and Toy manufacturers were
sued by the government for having secret price
fixing meetings.
100
Characteristics of Cartels

1. Cartels set price and output at an agreed upon
   price
2. Firms require identical or highly similar demand
   and costs
3. Cartel must have a way to punish cheaters
4. Together they act as a monopoly

Graphically
101
CARTELS AND OTHER COLLUSION
Colluding Oligopolists Will Split the Monopoly
Profits.
102
Kinked Demand Curve
103
Kinked Demand Curve Model
The kinked demand curve model is a graphic
portrayal of the interdependency of noncollusive
firms.
Noncollusive firms are likely to react to
competitors pricing in two ways
1. Match price-If one firm cuts its prices, then
the other firms follow suit causing inelastic
demand
2. Ignore change-If one firm raises prices,
others maintain same price causing elastic demand
104
KINKED DEMAND THEORY
The demand and MR curves if other firms match
lower pricing
If this firm lowers its price and others follow,
Qd will increase mildly
Price
D1
MR1
Quantity
105
KINKED DEMAND THEORY
The demand and MR curves if other firms ignore
higher pricing
If this firm increases its price and others
ignore it, Qd for this firm will decrease
significantly
Price
D2
MR2
Quantity
106
Two sets of curves based on the pricing decisions
of other firms
The firms demand and marginal revenue curves
Price
D2
MR2
D1
MR1
Quantity
107
Two sets of curves based on the pricing decisions
of other firms
Rivals tend to follow a price cut
Price
D2
MR2
D1
MR1
Quantity
108
Two sets of curves based on the pricing decisions
of other firms
Rivals tend to follow a price cut or ignore
a price increase
Price
D2
MR2
D1
MR1
Quantity
109
Two sets of curves based on the pricing decisions
of other firms
Effectively creating a kinked demand curve
Price
D2
MR2
D1
MR1
Quantity
110
Two sets of curves based on the pricing decisions
of other firms
Effectively creating a kinked demand curve
Price
D
Quantity
111
Two sets of curves based on the pricing decisions
of other firms
What about MR?
Price
D2
MR2
D1
MR1
Quantity
112
Two sets of curves based on the pricing decisions
of other firms
Since we use sections of both MR curves, the MR
has a vertical gap.
MR2
Price
D
MR1
Quantity
113
KINKED DEMAND THEORY NONCOLLUSIVE OLIGOPOLY
Profit maximization MR MC occurs at the kink.
MR2
Price
D
MR1
Quantity
114
KINKED DEMAND THEORY NONCOLLUSIVE OLIGOPOLY
Notice that changes in costs dont easily change
profit maximizing output.
MR2
Price
D
MR1
Quantity
115
KINKED DEMAND THEORY NONCOLLUSIVE OLIGOPOLY
The result is stable (or sticky) prices for
noncolluding firms.
MR2
Price
D
MR1
Quantity