principles of economics session 8. topics to be covered imperfect competition & market power ...
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Principles of Economics
Session 8
Topics To Be Covered
Imperfect Competition & Market Power
Characteristics of Oligopoly
Collusion vs. Competition
Kinked Demand Curve Model
Game Theory
Characteristics of Monopolistic Competition
Topics To Be Covered
Profits and Losses of the Monopolistic Firm
Long-Run Equilibrium of Monopolistic
Competitive Market
Monopolistic vs. Perfect Competition
Comparison and Contrast between
Four Types of Market Structure
Standards Wars
Four Types of Market Structure
Monopoly
• Tap water
• Cable TV
Oligopoly
• Automobile
• Crude oil
Monopolistic
Competition
Perfect Competition
• Clothing
• Furniture
• Wheat
• Rice
Number of Firms
Type of ProductsOne firm Few
firms Differentiated products
Many firms
Identical products
Imperfect Competition
Imperfect competition refers to those market structures that fall between perfect competition and
pure monopoly.
Imperfect Competition
Imperfect competition includes industries in which firms have competitors but do not face so
much competition that they are price takers.
Types of Imperfectly Competitive Markets
Oligopoly Only a few sellers, each offering a
similar or identical product to the others.
Monopolistic Competition Many firms selling products that are
similar but not identical.
Market Power
Market power is the degree of control that a firm or group of firms has over the price and production decisions in an industry.
The monopolistic firm has a high degree of market power while perfectly competitive firms have no market power.
Measures of market power: concentration ratio, Lerner’s index, Herfindahl-Hirschman index
Concentration Ratio
Concentration ratio is the percentage of an industry’s total output accounted for by the largest firms.
A typical measure is the four-firm concentration ratio, which is the fraction of output accounted for by the four largest firms.
Lerner’s Index
Lerner’s index is an efficient way to measure the market power.
L = (P - MC)/P
Quantity0
Costs, Revenueand Price
D= AR
MC
MRQMAX
E
ATC
P
MC
P-MC
P
Herfindahl-Hirschman Index
HHI is calculated by squaring the market share of each firm competing in a market and then summing the resulting numbers.
i
iSHHI 2＝
HHI ranges from a minimum of close to 0 to a maximum of 10,000.
Herfindahl-Hirschman Index
If HHI ＜ 1,000, the industry is considered as competitive.
If 1,000 ≤ HHI ＜ 1,800, the industry is considered as moderately concentrated.
If HHI ≥ 1,800, the industry is considered as highly concentrated.
As a general rule, mergers that increase the HHI by more than 100 points in concentrated markets raise antitrust concerns.
Herfindahl-Hirschman Index
If there were only one firm in an industry, that firm would have 100% market share and the HHI would be equal to 10,000 (1002).
If there were thousands of firms competing, each would have a nearly 0% market share and the HHI would be close to zero, indicating nearly perfect competition.
Characteristics of an Oligopoly Market
Small number of suppliers Similar or identical products Barrier to entry Interdependent firms
Small Number of Suppliers
As small as they might cooperate or collude in such strategies as pricing.
Examples: automobiles, steel, computers
Barriers to Entry
Scale economiesPatentsTechnologyName recognition
Interdependence
In perfect competition, the producers do not have to consider a rival’s response when choosing output and price.
In oligopoly the producers must consider the response of competitors when choosing output and price.
Collusive Oligopoly
Oligigolopists can collude to form a cartel in which they work together to raise prices and restrict output.
Collusive oligopolists at large can profit as a monopoly does.
profit
Collusive Oligopoly
Q0
D
MC
MR
Collusive Quantity
BCollusiveprice
E
ATC
Averagetotal cost D C
P
Obstacles ofEffective Collusion
In the vast majority of countries, collusion is illegal.
Members of the cartel are tempted to cheat on the agreement.
With the development of international trade, many oligopolists face intense competition from foreign firms as well as domestic companies.
The Kinked Demand Curve Model
The kinked demand curve model describes a situation in which a firm assumes that other firms will match its price reductions but will not follow price increases.
The optimal strategy in such a situation is frequently to leave the price at the current level and to rely on nonprice competition rather than price competition.
The model explains the price rigidity in the oligopolistic industry.
The Kinked Demand Curve ModelP
Q 0
If the producer raises price thecompetitors will not and the
demand will be relatively elastic.
If the producer lowers price thecompetitors will follow and the
demand will be relatively inelastic.
The Kinked Demand CurveP
Q0
P*
Q*
MC
MC”
So long as marginal cost is in the vertical region of the marginal
revenue curve, price and output will remain constant.
MR
DMC’
The Equilibrium for an Oligopoly
A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.
How the Size of an Oligopoly Affects the Market Outcome
As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market.
The price approaches marginal cost, and the quantity produced approaches the socially efficient level.
Game Theory: Competition vs. Collusion
Game theory is the study of how people behave in strategic situations.
Strategic situations are those in which each person, in deciding what actions to take, must consider how others might respond to that action.
Game Theory: Competition vs. Collusion
Because the number of firms in an oligopolistic market is small, each firm must act strategically.
Each firm knows that its profit depends not only on how much it produced but also on how much the other firms produce.
An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face.
Two prisoners have been accused of collaborating in a crime.
They are in separate jail cells and cannot communicate.
Each has been asked to confess to the crime.
The Prisoners’ Dilemma
If they both confess, they both will be sentenced to 5-year imprisonment.
If neither confesses, they both will be sentenced to 2-year imprisonment.
If one confesses and the other does not, the one who confesses will be sentenced to 1-year imprisonment while the other will be sentenced to 10-year imprisonment.
The Prisoners’ Dilemma
The Prisoners’ DilemmaPeter’s Decision
Confess Remain Silent
Confess
Remain Silent
Bob’s Decision
-5
-5
-1
-10
-2
-2
-10
-1
A
DC
B
The Dominant Strategy
The dominant strategy is a situation where one player has a best strategy
no matter what strategy the other player follows.
The Dominant Equilibrium
When all players have a dominant strategy, we say that the outcome is
a dominant equilibrium.
The Dominant EquilibriumPeter’s Price
Normal Price Price War
Normal Price
Price War
Bob’s Price
$10
$10
-$10
-$100
-$50
-$50
A
DC
B
-$10
-$100
Both Peter and Bob have a dominant strategy, for the best decision for them is to choose the normal price.
There is a dominant equilibrium for them in cell A.
The Dominant Equilibrium
Collusion vs. Competition
Q
D
MC
MR
ATC
P
Q
P
The Nash Equilibrium
A Nash equilibrium is one in which no player can improve his
or her payoff given the other player’s strategy.
The Nash EquilibriumPeter’s Price
High Price Normal Price
High Price
Normal War
Bob’s Price
$100
$200
-$30
$150
$10
$10
A
DC
B
-$20
$150
Bob has a dominant strategy, while Peter does not. However, they can reach a Nash equilibrium in cell D. Given Bob’s strategy to charge a normal price, Peter can can do no better than to charge a normal price.
A dominant equilibrium is necessarily a Nash equilibrium, but not vice versa.
The Nash Equilibrium
The Invisible-Hand GamePeter’s Strategy
Competitive Output
Low Output
CompetitiveOutput
Low Output
Bob’s Strateg
y
$0
$0
$600
-$50
$300
$250
A
DC
B
$800
-$100
NI ＝ $5000 NI ＝ $4400
NI ＝ $4500 NI ＝ $4000
Collusion vs. Competition
Self-interest makes it difficult for the oligopoly to maintain a cooperative
outcome with low production, high prices, and monopoly profits. However,
competition is more beneficial to society and the invisible hand can make the
economy more efficient.
The Advertising GamePeter’s Decision
Advertise Don’t Advertise
Advertise
Don’t Advertis
e
Bob’s Decision
$30
$30
$50
$20
$40
$40
A
DC
B
$50
$20
The Pollution GamePeter Steel
Low Pollution High Pollution
Low Pollution
High Pollutio
n
Bob Steel
$100
$100
-$30
$120
$100
$100
A
DC
B
-$30
$120
The Winner-Take-All GameWinner
Work in Standard Industry
Runner-Up
$50
$50
$50
$200
$300
$0
A
DC
B
$50
$300
Work in Winner-Take-
All Industr
y
Work inStandard Industry
Work in Winner-Take-All Industry
NI ＝ $100 NI ＝ $350
NI ＝ $250 NI ＝ $300
Why People Sometimes Cooperate
Firms that care about future profits will cooperate in repeated games rather than cheating in a
single game to achieve a one-time gain.
Public Policy Toward Oligopolies
Cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too low and prices that ar
e too high.
Monopolistic Competition
Markets of monopolistic competition are those that have features of both competition and monopoly.
It is the most common type of market structure.
Characteristics of Monopolistic Competition
Many sellers Differentiated products Free entry and exit
Many Sellers
There are many firms competing for the same group of customers.
Examples: CDs, movies, restaurants, furniture, etc.
Differentiated Products
Each firm produces a product that is at least slightly different from those of other firms.
Rather than being a price taker, the firm can change its output and consequently influence the price of the product.
Free Entry or Exit
Firms can enter or exit the market without restriction.
It is the striking difference from the monopolistic market which has high barriers to entry and exit.
Quantity of Output
A PerfectlyCompetitive Firm
A Monopolistically Competitive Firm
0
Price
D=P=AR=MR
0 Quantity of Output
Price
D=P=AR
Demand Curves
Profit Maximization for Monopolistic Competitors
Quantity0
Price
DProfits
MCATC
MR
Profit-maximizing quantity
Averagetotal cost
Price
Loss Minimization for Monopolistic Competitors
Quantity0
Price
DLosses
MCATC
MR
Loss-minimizing quantity
ATC
Price
The Long-Run Equilibrium
Firms will enter and exit until the firms are making exactly
zero economic profits.
A Monopolistic Competitor in the Long Run
Quantity
Price
0
DemandMR
ATC
MC
Profit-maximizingquantity
P=ATC
Economic Profits and Monopolistic Competition
Economic profits encourage new firms toenter the market. The entry will:
Increase the number of products offered. Reduce demand faced by firms already in the
market. Shift the demand curve to the left. Decrease economic profit to zero in the long
run.
Economic Losses and Monopolistic Competition
Economic losses encourage firms toexit the market. The exit will:
Decrease the number of products offered. Increase demand faced by the remaining
firms. Shift the remaining firms’ demand curves to
the right. Increase the remaining firms’ accounting
profit until economic profit reaches zero in the long run.
Two Characteristics of Long-Run Equilibrium
As in a monopoly, price exceeds marginal cost. P ＞MC
As in a competitive market, price equals average total cost. P=ATC
Monopolistic versus Perfect Competition
There are two noteworthy differences between monopolistic
and perfect competition—excess capacity and markup.
Monopolistic versus Perfect Competition
Quantity Quantity
Price
P = MR(deman
d curve)
MCATC
Price
Demand
MCATC
P = MC
Excess capacity
Marginal cost
Markup
MR
Quantity produced = Efficient scale
Efficientscale
Monopolistically Competitive Firm
PerfectlyCompetitive Firm
Quantityproduced
Price
Excess Capacity
There is no excess capacity in perfect competition in the long run.
Free entry results in competitive firms producing at the point where average total cost is minimized, which is the efficient scale of the firm.
Excess Capacity
There is excess capacity in monopolistic competition in the long run.
In monopolistic competition, output is less than the efficient scale of perfect competition.
Markup Over Marginal Cost
For a competitive firm, price equals marginal cost.
For a monopolistically competitive firm, price exceeds marginal cost.
Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically competitive firm.
The Number of Suppliersand Efficiency
The larger the number of firms in the market, the more elastic will be the
demand for each firm's product, and the more efficient will be the market
Monopolistic Competition and the Welfare of Society
There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.
Monopolistic competition does not have all the desirable properties of perfect competition.
Deadweight Loss
Monopolistic Competition and the Welfare of Society
Quantity
Price
0
DemandMR
ATC
MC
Profit-maximizingquantity
P=ATC
Differentiation andMarket Power
The more differentiation of the product, the greater the market power. Advertising
and innovation are means to realize the product differentiation and get more
profit.
Advertising
When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product.
Overall, about 2 percent of total revenue is spent on advertising throughout the world.
Advertising
Critics of advertising argue that firms advertise in order to manipulate people’s tastes.
They also argue that it impedes competition by implying that products are more different than they truly are.
Advertising
Defenders argue that advertising provides information to consumers.
They also argue that advertising increases competition by offering a greater variety of products and prices.
The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.
Brand Names
Critics argue that brand names cause consumers to perceive differences that do not really exist.
Economists have argued that brand names may be a useful way for consumers to ensure that the goods they are buying are of high quality. providing information about quality. giving firms incentive to maintain high quality.
Four Types of Market Structure
Perf. Comp. Monopol
y
Collusive
Oligopoly
Monop. Comp.
No. of Firms
Many One Few Many
Collusion
None None Yes None
P vs. MC P = MC P ＞ MC P ＞ MC P ＞ MC
P vs. LAC
P = LAC P ＞ LAC
P ＞ LAC
P = LAC
Efficiency
Efficient Large Loss
Large Loss
Mod. to Sm. Loss
Standards Wars
Two Basic Tactics
Preemption Build installed base early But watch out for rapid technological progre
ss
Expectations management Manage expectations But watch out for vaporware
Once You’ve WonStay on guard
MinitelOffer a migration pathCommoditize complementary products
IntelCompeting against your own installed ba
se Intel again Durable goods monopoly
Once You’ve Won, cont’d.
Attract important complementorsLeverage installed base
Expand network geographically
Stay a leader Develop proprietary extensions
What if You Fall Behind? Adapters and interconnection
Wordperfect Borland v. Lotus Translators, etc
Survival pricing Hard to pull off Different from penetration pricing
Legal approaches Sun v. Microsoft
Microsoft v. Netscape
Rival evolutionsLow switching costsSmall network externalitesStrategies
Preemption Penetration pricing Expectations management Alliances
Assignment
Review Chapter 10 and 11Answer questions on P186 and 205Preview Chapter 12 and 15
Thanks
Economic Profit versus Accounting Profit
RevenueTotalopportunitycosts
How an EconomistViews a Firm
Explicitcosts
Economicprofit
Implicitcosts
Explicitcosts
Accountingprofit
How an AccountantViews a Firm
Revenue
The Long-Run Equilibrium of Perfectly Competitive Market
Quantity0
Price
P = AR = MR
ATC
MC
P
Q
The Long Run Equilibrium of Monopolistic Market
Quantity0
Costs andRevenue
D= AR
MC
MR
QMAX
BMonopolyprice
E
ATC
MarginalCost D C