11

CH 8MARKET STRUCTURE AND OUTPUT-PRICING DECISIONS

Firms output and pricing decisions depend on the current market structure in which the firm is operating i.e.

“How much control over price we have.”

whether the firm is competing in perfect competition, monopoly, monopolistic competition or oligopoly situation

22

Competition vs. Monopoly

One useful way in which issues of competition and monopoly can be investigated is called the Structure, Conduct and Performance Model

33

Competition vs. Monopoly continued

MarketStructure Conduct Performance

e.g. number ofbuyers and sellers(the size of firms)

e.g. firm's goals,pricing and output,their investments

e.g. efficiency,profitability and growth

44

Perfect Competition Firms are price takers

they face a perfectly elastic demand curve

market price changes only if demand or supply changes

Given the market price, what is the appropriate level of production?

Since market price will settle at the point where only normal profits are earned output will settle where

p = MC = AC = MR

AC

P*

Output

MC

D=MR=AR

q*

55

Industry Demand Increase and the Long-Run Industry Supply Curve

S1S2

D1D2

Long-run S

P

Q

a) Constant industry costs

a

b

c

66

Industry Demand Increase and The Long-Run Industry Supply Curve continued

S1 S2

D1D2

Long-run S

P

Qb) Increasing industry costs: external

diseconomies of scale

a

b

c

77

Industry Demand Increase and The Long-Run Industry Supply Curve continued

S1 S2

D1 D2

Long-run S

P

Q

c) Decreasing industry costs: external economies of scale

a

b

c

88

Why is perfect competition so rare in the real world - if it even exists at all? One important reason for this has to

do with economies of scale:Perfect competition requires there to be many firms (non having a large market share). Firms must therefore be small under perfect competition - too small for economies of scale.

DLAC1

LAC2

LAC3

Output

99

BUT once a firm expands sufficiently to

achieve economies of scale, it will usually gain market power

it will be able to undercut the prices of smaller firms and so drive them out of business perfect competition will be destroyed

therefore, perfect competition could only exist in an industry, if there were no (or virtually no) economies of scale

1010

Perfect Competition and Public InterestPossible pluses: the fact that p = mc leads to efficient

resource allocation competition between firms will spur to

efficiency will encourage the development of new

technology there is no point in advertising!? in long-run equilibrium: LRAC at its

minimum, so company producing at the least-cost output

consumers gain from low prices quick response to changed consumer

tastes

1111

Perfect Competition and Public Interest continued

Pitfalls of perfect competition:

firms may be too small to afford R & D!

produces only undifferentiated products how about the taste of variety?!

1212

Monopoly

Why do monopolies exist?

Barriers to entry Control of scares resources or

inputfor instance diamonds (De Beers)

Economies of scalenatural monopolies

Technological superioritybut not a guarantee if network externalities exist

Government-created barriersAlko, patents, copyrights

1313

Demand function facing a monopoly is the market demand for the product

Monopoly firm’s ability to set its market price is limited by the demand curve (demand elasticity) downward sloping demand and MR-

curves

But supernormal profits may be earned even in the long run depends on how contestable the market

is

P1

Q1

MCATC

D = AR

MR

1414

Monopoly and Public Interest

Disadvantages of monopoly:

higher prices and lower output than under perfect competition

possibility of higher cost curves due to lack of competition loss of efficiency

unequal distribution of income monopoly profits

1515

Monopoly and Public Interest continued

Advantages of monopoly:

economies of scale

possibility of lower cost curves due to more research and development and more investment

competition for corporate control

innovation and new products

1616

Monopolistic Competition Firms have some degree of market

power but demand curve typically flatter

than in monopoly since there is more competition

Output-pricing decision is defined by MR = MC as always

the absence of entry barriers means that super normal profits are competed away...

firms end up producing where p = AC, but AC not at its minimum as in perfect competition, also p > MC

Output

DMR

ACMC

FP = AC1

Q1

1717

Limitations of Monopolistic Competition Model

Information may be imperfect; firms will not enter an industry if they are unaware of the supernormal profits currently being made

Firms are likely to be different from each other not only in the product they produce or the service they offer, but also in their size and in their cost structure. Also the entry may not be completely unrestricted

The model concentrates on price-output decisions; in practice the profit-maximizing firm under monopolistic competition will also need to decide the exact variety of products to produce and how much to spend on advertising

1818

Limitations of Monopolistic Competition Model continued

Compared to perfect competition: less will be sold at a higher price firms will not be producing at the

least-cost point (i.e. min AC) = firms have excess capacity

On the other hand it is often argued that these wastes are insignificant (since highly elastic demand curves and some scale economies gained) and perhaps well compensated to the consumer by the great variety of products to choose from

1919

Oligopoly

A market dominated by a few large firms—imperfect competition

How concentrated is an industry? consider the market share of four

largest firms

Some highly concentrated industries (in the world or in a country):

mobile phones, paper industry, cigarettes, batteries, automobiles, banking, breweries, airplane industry, oil industry, etc.

2020

Oligopoly continued

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

2121

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

2222

Collusion is difficult if:

There are many firms in the industry

The product is not standardized Demand and cost conditions

are changing rapidly There are no barriers to entry Firms have surplus capacity

2323

Tacit Collusion: Price Leadership Dominant firm price leadership

• Dominant firm sets the price for the industry, but lets followers sell all they want at that price. Dominant firm will provide rest of the market demand

• Followers, like in perfect competition, accept the price as given their joint supply is the sum of their MC curves (like in perfect competition)

2424

The leader’s D-curve can be seen as that portion of market demand unfilled by the other firms, i.e. the difference between the market demand at each price and supply by followers at each price

Sall other firms

Dmarket

DleaderP1

P2

Q

a

b

MRleader

MCleader

PL

QF QT

Leader sets MR = MC

QL = QT - QF

2525

Kinked demand for a firm under oligopoly

QO

P1

Q1

D

demand in response to a price reduction is likely to be relatively inelastic

The firm may expect rivals to respond if it reduces its price, as this will be seen as an aggressive move, so

…but for a price increase rivals are less likely to react, so demand may be relatively elastic above P1

Demand curve kinked at current price:

Tacit collusion outcome

2626

Stable price under conditions of a kinked demand curve

QO

P1

Q1

D ARa

MR

When Q < Q1, the MR curve corresponds to the shallow part of the AR curve

2727

Stable price under conditions of a kinked demand curve continued

QO

P1

Q1MR

a

b

D AR

At Q > Q1, the MR curve will correspond to the steep part of the AR curve

Note the cap between points a and b

2828

Stable price under conditions of a kinked demand curve

QO

P1

Q1 MR

a

bD AR

•Price will tend to be stable, even in the face of an increase in marginal cost:

if MC lies anywhere between a and b the profit-maximizing price and output will be P1 and Q1

2929

Stable price under conditions of a kinked demand curve continued

QO

P1

Q1

MC2

MC1

MR

a

bD AR

3030

Non-Collusive Oligopoly: Game Theory

A method of analyzing strategic behavior behavior of a firm will depend on how it

thinks its rivals will react to its policies

Invented by John von Neuman (1937) and extended with Oskar Morgenstern

(1944)

John Nash: Nash equilibrium (1949-1950) a dominant strategy equilibrium

3131

Prisoners’ Dilemma – an one-shot game A two-person, non-zero-sum, non-

cooperative game with dominant strategy

Dilemma: To confess or not to confess the crime committed

If confesses, can get a shorter prison time, but will the partner in crime confess or not?

Best joint outcome if both would deny

If only one talks he gets a minimum sentence and the other the maximum

If both confess moderate outcome for both

3232

Prisoners’ Dilemma: Payoff Matrix

John’s strategiesConfess Deny

Confess

Deny

Bob

’s s

trate

gie

s 3 years

3 years

2 years

2 years

10 years

10 years

1 year

1 year

3333

A Strategic Game Example

Soap Wars Procter & Gamble and Unilever are

engaged in a long running “soap war”, each company trying to capture a larger proportion of the detergent market

P&G has just started a huge marketing campaign to launch their new Ariel tablets and trying to convince the public that their product is better than the Persil tablets introduced by Unilever a year ago

3434

UK Detergent Market 1995-1998

ArielPercil

0

10

20

30

40

50

60

Unilever P&G

1995

1998

3535

The Two companies are constantly looking for strategies to raise market share and profits

One way to do that is product development Tablets introduced

Let’s consider this as a strategic game Tit-for-tat repeated game

3636

Soap Wars: A Strategic Game

Unilever’s strategies

No tablet Launch tablet

No tablet

Launch tabletP

roct

er&

Gam

ble

’s

stra

gegie

s

+8%

+8%

+12%

+12%

-4%

-4% +4%

+4%

3737

Duopoly Payoff Matrix: The equilibrium is a Nash equilibrium, both firms cheat

Company A’s strategies

Cheat ComplyC

om

pan

y B

’s s

trate

gie

s

£0Cheat

Comply

£0

-£1.0m

-£1.0m

+£4.5m

+£4.5m +£2m

+£2m

3838

Oligopoly and Public Interest If oligopolists act collusively and jointly

maximize industry profits, they will in effect be acting together like a monopoly and then the disadvantages to society would be the same as under monopoly

Further more, in two respects, oligopoly may be more disadvantageous than monopoly: Oligopolists are likely to engage in much

more extensive advertising than a monopolist Depending on the size of individual

oligopolists, there may be less scope for economies of scale to decrease the effects of market power

3939

Advantages of oligopoly to society over other market structures:

Can use part of the supernormal profits for R&D (incentive to do so higher than in monopoly)

Non-price competition through product differentiation may result in greater choice for the consumers

4040

Non-Price Competition

Product Developmentaims to develop products which will

sell well and which are different from rivals' products

leads to less elastic and potentially high demand

Advertisingto increase demand and to make

demand curve less elastic

Advertising and product development not only increase a firm's demand and hence revenue, they also involve increased costsso how much to spend in order to

maximize profit?

4141

The Changing Nature of Market Structure the market types that actually exist

in business situations are not always clear-cut or stable

the type of market in which a firm competes may change over the life of the products being sold

Prof. Michael Porter has introduced a useful way to incorporate the possibility of change in market structure into the analysis of business decision making

the model of "five competitive forces"

4242

The Porter Competitive Framework

Intra-Market Rivalry

Potential Entrants

Customers

Substitute Markets

Suppliers

Threat of new entrants

Bargaining power of buyers

Bargaining power of suppliers

Threat of substitute products or services