lecture 11 imperfect competition - lakehead universityflash.lakeheadu.ca/~kyu/b5017/b11.pdf · the...

Lecture 11 Imperfect CompetitionBusiness 5017 Managerial Economics

Kam Yu

Fall 2013

Outline

1 Introduction

2 Monopolistic Competition

3 OligopolyModelling RealityThe Stackelberg Leadership ModelCollusionRegulating Monopoly

4 Business RegulationPublic Interest TheoryEconomic Theory of Regulation

5 Market for Corporate ControlFirm IntegrationsAre Hostile Takeovers Efficient?

Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 2 / 29

Introduction

Monopolistic Competition and Oligopoly

We have so far studied two extreme forms of market structure.

In perfect competition, no single firm has the market power toinfluence the market price. In the long run firms make no economicprofit.

A monopolist which sells a product with no close substitute enjoygreat market power and makes economic profits in the long run.

Most market structures in our economy are something in between.

In monopolistic competition, each firm sells a differentiated productwith its market niche. The firms enjoy some market power and facetheir own downward sloping demand curves.

In an oligopoly, price, quantity, and therefore profits depend on theinteractions of the firm. The form of competition and marketoutcome are indeterminate.


Monopolistic Competition

Market Power

The market power of a monopolistic competitive firm depends on anumber of factors:

Number of competitors

Production capacity of competitors

Ease of new firms entering the market

Degree of product differentiation

Brand name recognition and loyalty

Price difference awareness of consumers



Short-Run Competition

A typical firm faces adownward sloping demandcurve, with a steepermarginal revenue curve.

Profit maximization isachieved by setting MC =MR.

The firm produces Qmc andcharges Pmc on the demandcurve.

Economic inefficiencycompared with the perfectlycompetitive market.



Long-Run Competition

As long as the firms are making economic profits, new firms will enterthe market.

The demand and MR curves of a typical firm shift down because ofincreased competitive. Demand also becomes more elastic.

This continues until all economic profits have eroded, with price Pmc1

and quantity Qmc1 on the LRAC curve.

Note that in the long run the firm is not producing at the minimumefficiency scale, meaning economic inefficiency.

This occurs as long as the demand curve facing an individual firm isnot perfectly elastic.

Firms in monopolistic competitive often engage in non-pricecompetitive such as advertisement and customer relationships.



Long-Run Profits


Oligopoly Modelling Reality

Just a Handful of Sellers

Typically just a few sellers in a market with not much productdifferentiation. Barriers to entry are high.

Demands are more inelastic than that in a monopolistic competition.Therefore the oligopolists have more market power.

Consequently if an oligopolist behaves like a monopolist, thedead-weight loss is larger than that of a monopolistic competitivefirm.

However, this is not always the case. Pricing decisions of oligopolistsare mutually interdependent. There is a wide variety of economicmodels on their behaviours.


Oligopoly Modelling Reality

Oligopolist as a Monopolist


Oligopoly The Stackelberg Leadership Model

One Market Leader

The market is dominated by one big producer with cost advantage(advanced technology, patents, big brand name, etc.).

The rest of the firms are followers with no market power.

The total supply curve of the followers is the sum of their MC curves.Without the leader, this supply curve MC c meets the market demandcurve Dm at price P1 and quantity Q2.

Excess demand exists at any price below P1, these excess demandsbecome the demand curve Dd for the dominant producer, withcorresponding marginal revenue MRd .

The dominant producer maximizes profit by setting MC = MR withthe price-quantity combination (Pd ,Qd).

The followers are price takers, now face market price Pd . The excessdemand between the consumers and the followers is Q3 − Q1, whichis equal to Qd .


Oligopoly The Stackelberg Leadership Model

Price Leader and Followers


Oligopoly Collusion

How Cartels are Formed

If product differentiation is weak, consumers are more price sensitive.Pricing becomes the main tool in competition among the oligopolists.

There are strong incentives for the firm to form a cartel and behavecollectively like a monopoly.

The cartel chooses the monopoly price-quantity combination tomaximize profit, which is shared by its members.

With the high monopoly price, however, each individual firm in thecartel has an incentive to cheat, making even more profit byincreasing production.

To avoid collapse, the cartel must have a mechanism in place topunish the cheaters.


Oligopoly Collusion

An Example of Duopoly

Two identical firms withconstant returns to scaletechnology.

They form a cartel to maximizejoint profit with (Pm,Qm). Thismeans each firm produces at alevel Q1 = Qm/2.

After the collusion agreement,each firm has the incentive tolower price a little to P1 andcapture almost the wholemonopoly market.

But total profit goes down ifboth cheat.


Oligopoly Collusion

Back to Game Theory

The above colluding duopoly can be described by a Prisoner’sDilemma model.

Assume that the two firms, A and B, have two choices, high price orlow price. Their incentive can be analyzed with the payoff matrix.

For Firm A, no matter what Firm B chooses, its best strategy is tochoose low price. The same is true for Firm B.

Therefore the dominant strategy is low price for both firms, resultingin the inefficient outcome (500, 500).

This outcome is also a Nash equilibrium, which consists of the beststrategy for every player given the action of all the other players. Inother words, no player has the incentive to change his/her choice.

Therefore in a one-shot game the collusion will fail. In a repeatedgame setting, the behaviours are more complicated.


Oligopoly Collusion

Payoff Matrix of a Duopoly


Oligopoly Collusion

Cartels with Lagged Demand

Recall that when a product exhibits lagged demand due to networkeffect or rational addiction, a firm has the incentive to lower pricenow so that demand will be higher in the future.

This applies to a cartel as well. But individual firm has the incentiveto free-ride the other firms.

Since the game is inherently dynamic, actual behaviours depends onthe mechanism design of the cartel.


Oligopoly Collusion

Government-Supported Cartels

In a lot of cases the transaction costs of maintaining a cartel(negotiating, monitoring, and enforcing the agreement) is higher thanthe benefits of collusion.

The problem may be resolved with a third party doing the monitoringand enforcement task.

A good candidate for this third party is the government. Withlegislative and executive power, the government can be very efficientin maintaining a cartel.

This is why some industries lobby for government regulations oroppose deregulation. The effects of regulations can suppresscompetition.

Examples: airline regulations, liquor licence, banning Sundayshopping, professional licensing, etc.


Oligopoly Regulating Monopoly

Natural Monopoly

When the long-run average cost is declining within the range ofmarket demand, it is cost effective to have a single producer.

The natural monopoly is socially inefficient, however, if it exploitsconsumers with its market power. The government usually steps in toregulate the monopoly.

Instead of the monopolist’s profit maximizing (Pm,Qm), thegovernment can impose a price ceiling at P1, where the LRAC meetsthe market demand curve.

This may occur naturally without government intervention in acontestable market. Even though there is a high fixed cost, somewell-financed firms may see the monopoly profit as a sign to enter themarket.

The threat of a price war with a new competitor keeps the naturalmonopolist in check and charge a price close to the socially efficientlevel at P1.


Oligopoly Regulating Monopoly

A Natural Monopolist


Business Regulation Public Interest Theory

“The Government is the Problem”

Many sectors in the economy are subject to various degree ofgovernment regulation.

In Canada the most heavily regulated sectors are health care,education, transportation, telecommunication, agriculture, andelectricity.

Common reasons for regulation are social insurance, monopoly power,public safety, market stability, preservation of culture and languages,etc.

Some economists think that excessive government regulation hindersthe operation of the free markets and creates inefficiency.

Others try to explain regulation from an institutional economicsperspective.



Regulating Cartels and Natural Monopoly

Cartels and natural monopolyare common targets bygovernment.

The objective is to eliminate thedead-weight welfare loss in theindustry.

Determining the exact values ofthe socially efficientprice-quantity combination(Pc ,Qc), however, is not atrivial task.

Cost structure of a monopolistis private to the firm. It has theincentive to mislead thegovernment.



Subsidizing a Monopoly

In some cases even the monopoly does not exploit the consumers andproduces at the output level that price equals LRAC, it is still notsocially efficient.

This is because LRAC is declining so that LRMC is below it.Consumers’ willingness to pay at the margin is still higher than themarginal cost of production.

To induce the monopolist to produce at the socially efficient outputQ2, the government can provide a subsidy to the firm equals to theeconomic losses.

This, however, gives the incentive to the managers to turn the subsidyinto perks and increased pays. Unions members of the firm have theincentives to negotiate pay raise and more fringe benefits.

LRAC and LRMC will shift upward, raising market price and reducingoutput.



Underproduction and Government Subsidy


Business Regulation Economic Theory of Regulation

Regulation as a Marketable Product

The provision of government regulation can be viewed as a marketservice, subject to the forces of supply and demand.

On the supply side: benefits include campaign contributions, lucrativeconsulting jobs, or sometimes outright bribery.

On the demand side:

Monitoring and enforcing cartel agreements to prevent competitionErecting barriers to entry and establishing import restrictionsProviding subsidiesPreventing deregulation

Free-riding problems exist when the industry is big and diverse.

The economic theory of regulation provides a useful conceptualframework but is less successful in predicting the outcomes of specificindustries.


Market for Corporate Control Firm Integrations

Mergers, Acquisitions, and Hostile Takeover

The economic theory of market can be applied to consumer orindustrial goods and services and provision of government regulation.It can also be applied to the market of corporate control.

Firms can be bought and sold as investment vehicles.

When firms change hand under “friendly” agreements, it is called asmergers (TD Bank and Canada Trust) or acquisitions (WalmartCanada buying stores from Zellers).

Economists classify M&A as horizontal or vertical integrations.

Occasionally “corporate raiders” offer a deal directly to shareholderswithout management’s approval. These are labelled as hostiletakeover.



Managerial Monopolies

Internal departments of a firm can behave like a monopoly, restrictingservices and requiring larger budget of operations.

Management uses outsourcing as a tool to avoid inefficiency ofinternal monopolies.

If the management is unable or unwilling to tackle these inefficiency,the company’s stock value may become depressed.

This provides incentive for an outside to take over the firm, improveits efficiency, and resell it at a profit.

The threat of a hostile takeover keeps internal monopolisticbehaviours in check.



Hostile Takeover and Principal-Agent Problem

In a classical principal-agent situation, the objective of themanagement of a firm is not aligned with that of the shareholders.

In a hostile takeover, the management always oppose the firm beingtaken over. The new owner of the firm threatens their pay, perks, andprivileges. Often the management team will be replaced.

The shareholders of the target firm, on the other hand, are the mainbeneficiaries of the takeover. They see their stock prices go up about50 percent.

Following this argument, a hostile takeover bid is usually a signal thatthe target firm suffers from principal-agent problems. Outsiders seethe opportunity to improve the operation of the firm.


Market for Corporate Control Are Hostile Takeovers Efficient?

Cost-Benefit Analysis of Takeovers

The shareholders of the target firm usually gain from a hostiletakeover. What about the other players?

Winner’s curse — Imagine that bidders of a firm have their ownsubjective evaluation on the value of the target firm. The one whichwins the bid has the most optimistic outlook.

The winning firm may overbid compared with the average bid. Thismay potential hurt the shareholders of the acquiring firm.

Empirical studies do not support this argument, shareholders of theacquiring firm on the average gain 1 to 3 percent in their stock prices.

Firms which actually suffer the winer’s curse, however, are more likelyto become the target of hostile takeovers themselves.


Market for Corporate Control Are Hostile Takeovers Efficient?

Other Third Parties

Bondholders — A hostile takeover may increase the risk the targetfirms or the acquiring firm. While the shareholders of these firm gethigher expected returns on the operation, bondholders may sufferbecause of the additional risk.

Empirical studies find that losses by bondholders are minimal.

Laid-off workers — Corporate raiders are often accused of laying offworkers of the newly acquired firm.

The argument is circular because the objective of the takeover is toimprove the efficiency of the firm so that it converges to its optimalsize.


lecture 11 imperfect competition - lakehead universityflash.lakeheadu.ca/~kyu/b5017/b11.pdf · the...

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