BUSINESS ECONOMICS #8

Market Structure and Competitive Strategy 1: Competition vs Monopoly Dr Sarath Divisekera

Introduction
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The first half of the semester we devoted to understand market mechanism, the behaviour of key market players and determination of prices and outputs in the market place Now we are going to explore price-output decisions in details to further our standing and the emphasis here is the way in which markets are organised Note that the decisions of price-output which are taken by a firm(s) or by the industry are very much influenced by the form and structure of the market for goods and services. The structure of market - commodity market as well as factor market - is determined by the nature and pattern of competition which prevails. Market structure is best defined as the organisational and other characteristics of a market. We focus on those characteristics which affect the nature of competition and pricing (but it is important not to place too much emphasis simply on the market share of the existing firms in an industry).

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Market structures
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The process by which price and output are determined in the real world is strongly affected by the structure of the market. Economists hypothesise four different types of market structures

Pure Competition, Monopolistic Competition, Oligopoly, Pure Monopoly

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An Overview of Market Structures

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These different types of market structures are defined and distinguished from one another in terms of the number and size of the buyers and sellers of the product, the type of product bought and sold. Perfect competition at one extreme, pure monopoly at the opposite extreme, and monopolistic competition and oligopoly in between. This actually represents a continuum of competition

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Four market types

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Perfect competition (no market power) large number of relatively small buyers and sellers standardized product very easy market entry and exit Non price competition not possible Examples: perfect competition
agricultural financial

products instruments precious metals petroleum

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Four market types

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Monopoly (absolute market power, subject to government regulation) one firm, firm is the industry unique product or no close substitutes market entry and exit difficult or legally impossible Non price competition not necessary Examples: monopoly
Pharmaceuticals Microsoft petral

station on edge of desert

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Four market types

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Monopolistic competition (market power based on product differentiation) large number of small firms acting independently differentiated product market entry and exit relatively easy Non price competition very important Examples: monopolistic competition
Boutiques Restaurants repair

shops

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Monopolistic or Imperfect Competition

Some important points about monopolistic competition:

May Not

reflect a wide range of markets just one point on a scale reflects many degrees of imperfection Examples?

Four market types

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Oligopoly (product differentiation and/or the firms dominance of the market) small number of large mutually interdependent firms differentiated or standardized product market entry and exit difficult No nprice competition important Examples: oligopoly
oil

refining foods access

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processed Airlines internet

Oligopoly

Competition between the few

May be a large number of firms in the industry but the industry is dominated by a small number of very large producers

Concentration Ratio the proportion of total market sales (share) held by the top 3,4,5, etc firms:

A 4 firm concentration ratio of 75% means the top 4 firms account for 75% of all the sales in the industry

Oligopoly

Example: Music sales

The music industry has a 5-firm concentration ratio of 75%. Independents make up 25% of the market but there could be many thousands of firms that make up this independents group. An oligopolistic market structure therefore may have many firms in the industry but it is dominated by a few large sellers.

Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html

Oligopoly

Features of an oligopolistic market structure:

Price may be relatively stable across the industry kinked demand curve? Potential for collusion Behaviour of firms affected by what they believe their rivals might do interdependence of firms Goods could be homogenous or highly differentiated Branding and brand loyalty may be a potent source of competitive advantage Non-price competition may be prevalent Game theory can be used to explain some behaviour AC curve may be saucer shaped minimum efficient scale could occur over large range of output High barriers to entry

Oligopoly
Price
The kinked demand curve - an explanation for price stability? The Assume If The the firm firm principle the therefore, seeks firm of to is the lower effectively charging kinked its price demand a faces price to of 5 gain a kinked and a curve competitive producing demand rests on an curve advantage, the output principle forcing of its 100. itrivals to will follow maintain that: asuit. stable Any orgains rigid pricing it makes will If it chose to raise price above 5, its quickly be Oligopolistic structure. lost and the firms % change may in rivals a. would If a firm not raises follow its suit price, andits the firm demand will overcome this beby smaller engaging thanin the non% effectively rivals faces will not an follow elasticsuit demand reduction price competition. in price total revenue curve for its product (consumers would would b. If again a firm fall lowers as the its firm price, now its faces buy from the cheaper rivals). The % a relatively rivalsinelastic will all do demand the same curve. change in demand would be greater than the % change in price and TR would fall.

Total Revenue B

Total Revenue A Total Revenue B

100

Kinked D Curve D = Inelastic

D = elastic

Quantity

Duopoly

Market structure where the industry is dominated by two large producers

Collusion may be a possible feature Price leadership by the larger of the two firms may exist the smaller firm follows the price lead of the larger one Highly interdependent High barriers to entry Cournot Model French economist analysed duopoly suggested long run equilibrium would see equal market share and normal profit made In reality, local duopolies may exist

Continuum of Market Structure: A Summary

Pure Comp.
Perfect Substitutes No Barriers

Monopolistic Competition
Close Substitutes Low Barriers

Oligopoly

Pure Monopoly

No Close Substitutes Absolute Barriers Possible LR Ed= low

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High Barriers Possible LR Ed=?

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No LR No LR

Ed=infinite
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Ed=high

Perfect Competition
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Conditions necessary:

Large numbers of buyers and sellers Homogeneous product

When the products of all of the firms in a market are perfectly substitutable with one anotherthat is, when they are homogeneousno firm can raise the price of its product above the price of other firms without losing most or all of its business.

Price taker - Firm that has no influence over market price and thus takes the price as given -so face a horizontal demand curve

Because each individual firm sells a sufficiently small proportion of total market output, its decisions have no impact on market price.

Free entry and exit

Condition under which there are no special costs that make it difficult for a firm to enter (or exit) an industry.
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Perfect information

Pricing and output decisions in perfect competition

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Basic business decision: entering a market using the following questions: how much should we produce? if we produce such an amount, how much profit will we earn? if a loss rather than a profit is incurred, will it be worthwhile to continue in this market in the long run (in hopes that we will eventually earn a profit) or should we exit?
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8.3

MARGINAL REVENUE, MARGINAL COST, AND PROFIT MAXIMIZATION

Figure 8.2 Demand Curve Faced by a Competitive Firm

A competitive firm supplies only a small portion of the total output of all the firms in an industry. Therefore, the firm takes the market price of the product as given Price taker, Demand curve for any given firm is horizontal. Price is set by market at $4. Firm can sell as much or as little as desired at market price, but nothing if they raise P. In (a) the demand curve facing the firm is perfectly elastic, even though the market demand curve in (b) is downward sloping.

Pricing and output decisions in perfect competition

Perfectly elastic demand curve: consumers are willing to buy as much as the firm is willing to sell at the going market price firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price of the product Along this demand curve, marginal revenue, average revenue, and price are all equal. D = P = AR = MR no limit to the total revenue that the firm can gain in a perfectly competitive market

8.4

CHOOSING OUTPUT IN THE SHORT RUN

Output Rule: If a firm is producing any output, it should produce at the level at which marginal revenue equals marginal cost.

A Competitive Firm Making a Positive Profit

In the short run, the competitive firm maximizes its profit by choosing an output q* at which its marginal cost MC is equal to the price P (or marginal revenue MR) of its product. The profit of the firm is measured by the rectangle ABCD. Any change in output, whether lower at q1 or higher at q2, will lead to lower profit.

8.4
Figure 8.4

CHOOSING OUTPUT IN THE SHORT RUN

A Competitive Firm Incurring Losses

A competitive firm should shut down if price is below AVC. The firm may produce in the short run if price is greater than average variable cost.

Shut-Down Rule: The firm should shut down if the price of the product is less than the average variable cost of production at the profit-maximizing output.

8.5

THE COMPETITIVE FIRMS SHORT-RUN SUPPLY CURVE

The firms supply curve is the portion of the marginal cost curve for which marginal cost is greater than average variable cost.
The Short-Run Supply Curve for a Competitive Firm

In the short run, the firm chooses its output so that marginal cost MC is equal to price as long as the firm covers its average variable cost. The short-run supply curve is given by the crosshatched portion of the marginal cost curve.

8.6

THE SHORT-RUN MARKET SUPPLY CURVE

Producer surplus Sum over all units produced by a firm of differences between the market price of a good and the marginal cost of production.
Producer Surplus for a Firm

The producer surplus for a firm is measured by the yellow area below the market price and above the marginal cost curve, between outputs 0 and q*, the profit-maximizing output. Alternatively, it is equal to rectangle ABCD because the sum of all marginal costs up to q* is equal to the variable costs of producing q*.

8.6

Producer Surplus in the Short Run

Producer Surplus versus Profit Producer surplus = PS = R VC Profit = = R VC FC

Figure 8.12 Producer Surplus for a Market

The producer surplus for a market is the area below the market price and above the market supply curve, between 0 and output Q*.

Adjustments in the Long Run

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If economic profits are present new firms will come into the industry The Market price will fall The profit shrinks Input prices may go up Firms try to stay profitable by taking advantage of economies of scale Firms adopt an optimal size Economic profits tend toward zero
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8.7

CHOOSING OUTPUT IN THE LONG RUN

Long-Run Competitive Equilibrium

Entry and Exit

Figure 8.14 Long-Run Competitive Equilibrium

Initially the long-run equilibrium price of a product is $40 per unit, shown in (b) as the intersection of demand curve D and supply curve S1. In (a) we see that firms earn positive profits because longrun average cost reaches a minimum of $30 (at q2). Positive profit encourages entry of new firms and causes a shift to the right in the supply curve to S2, as shown in (b). The long-run equilibrium occurs at a price of $30, as shown in (a), where each firm earns zero profit and there is no incentive to enter or exit the industry.

Market Power: Monopoly and Monopsony

Market power - Ability of a seller or buyer to affect the price of a good. monopoly - Market with only one seller Monopsony - Market with only one buyer. Like a monopolist (a single seller), a monopsonist (Joan Robinson (1969, p. 215), has power over price through control of quantity. An example of pure monopsony is a firm that is the only buyer of labour in an isolated town. Such a firm is able to pay lower wages than it would under competition. Any examples you can think of??

Monopoly
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Conditions necessary
Single seller of product No close substitutes Significant barriers to entry Price maker/market power

Other extreme is the monopoly Unlike a competitive firm, monopoly has market power Thus a monopoly firm faces a downward sloping demand curve
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Why do monopolies exist?

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Exclusive Control Over Inputs Economies of Scale Patents Network Economies Government Licenses Or Franchises

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How do monopolies set price & quantity?

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Assume Profit Maximization Total Costs Are Just Like the Competitive Firm Total Revenue is Different From Competitive Firm

If a monopoly increases its price, the quantity it can sell will fall. If a monopoly decreases its price, the quantity it can sell will increase
Therefore total Revenue is Different From Competitive Firm need to lower prices to increase revenue, therefore MR < P

TR increases at a decreasing rate MR < AR = P = D Demand and marginal revenue are downward sloping Marginal revenue is below the demand curve

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10.1

MONOPOLY

Average Revenue and Marginal Revenue

Figure 10.1 Average and Marginal Revenue

Average and marginal revenue are shown for the demand curve P = 6 Q.

MR < AR = P = D

D = AR = P

Marginal Revenue & Marginal Cost

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Demand: Q = a - bP $ a/b

MR = MC
MC

MR = MC
MR Q0 Q1 a/2 D a Q

How can we choose between Q0 & Q1? 2011 Dr Sarath Divisekera 27/12/2011

Choosing the Right Output When MC = MR

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Demand: Q = a - bP $ a/b

For Q0, MC = MR, MC < 0, & MR < 0, but MC < MR. We have a minimum, not maximum!

MC For Q1, MC = MR, MC > 0, & MR < 0, so MC > MR. We have a maximum! MR Q0 Q1 a/2 D a Q

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Choosing the Right Price with the Right Output

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Demand: Q = a - bP $ a/b With the right output, we can find the right price by asking how much are people willing to pay.

P*

MC

MR Q1 a/2

D a Q

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Choosing the Right Price with the Right Output Example

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Two Conditions

MC = MR MC > MR P(Q) = 10 0.5Q TR = P(Q)Q = (10 0.5Q)Q = 10Q 0.5Q2 TR = MR = 10 Q For the first condition: MC = MR 2 = 10 Q* Q* = 8 For the second condition: MC = 0, so MC = 0 > MR = -1 P* = 10 0.5Q* = 10 0.58 = 6

Example: Suppose Q = 20 - 2P & MC = 2

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The Dynamics of a Monopolistic Market

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As a profit maximizer a monopoly may try to take advantage of economies of scale A monopoly tends to try to protect its monopolistic position A monopoly may take advantage of technological advances A monopoly may face changes in demand A monopoly may try to promote its product to maintain demand
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Things Change
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Demand may go down Cost could increase In an attempt to keep the potential competitors out, the monopolist may lower its price to near its average cost Rent seeking: an attempt to maintain its monopolistic position by influencing the political processes-e.g., zoning laws Closer substitutes may emerge
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The Case of Natural Monopolies

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A natural monopoly emerges out of competition among firms in an industry with extensive economies of scale; the downward-sloping segment of the LATC curve extends to or beyond the market capacity (or market demand). Smaller firms are gradually driven out by the larger (more efficient) firms. The surviving firm would become a (natural) monopoly. If unchecked, a natural monopoly behaves like a monopoly; it under-produces and overcharges.
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10.2

MONOPOLY POWER

Measuring Monopoly Power

Remember the important distinction between a perfectly competitive firm and a firm with monopoly power: For the competitive firm, price equals marginal cost; for the firm with monopoly power, price exceeds marginal cost.
Lerner Index of Monopoly Power Measure of monopoly power calculated as excess of price over marginal cost as a fraction of price. Mathematically:

This index of monopoly power can also be expressed in terms of the elasticity of demand facing the firm.

(10.4)

Efficiency and Economic Welfare

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Consumer surplus measures economic welfare from the buyer/consumer perspective. Producer surplus measures economic welfare from the seller/producer perspective.

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Consumer Surplus
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Consumer surplus is the amount a buyer is willing to pay for a product minus the amount the buyer actually pays. Consumer surplus is the area below the demand curve and above the market price. A lower market price will increase consumer surplus. A higher market price will reduce consumer surplus.

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Producer Surplus
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Producer surplus is the amount a seller is paid for a product minus the total variable cost of production. Producer surplus is equivalent to economic profit in the long run.

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Economic Welfare
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Economic welfare can be quantified as the sum of consumer surplus and producer surplus, i.e. equal weights assumed.

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Consumer Surplus and Producer Surplus: Market Equilibrium

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Price

A D

Supply

Consumer surplus Equilibrium price Producer surplus E

B C 0
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Demand

Equilibrium

Quantity

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Monopoly v. Perfect Competition

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Monopoly and perfect competition can be compared/contrasted by using consumer surplus and producer surplus (i.e. by using economic welfare/societal welfare measures).

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10.4

THE SOCIAL COSTS OF MONOPOLY POWER

Figure 10.10 Deadweight Loss from Monopoly Power

The shaded rectangle and triangles show changes in consumer and producer surplus when moving from competitive price and quantity, Pc and Qc, to a monopolists price and quantity, Pm and Qm . Because of the higher price, consumers lose A + B and producer gains A C. The deadweight loss is B + C.

10.4

THE SOCIAL COSTS OF MONOPOLY POWER

Rent Seeking

rent seeking Spending money in socially unproductive efforts to acquire, maintain, or exercise monopoly.
In 1996, the Archer Daniels Midland Company (ADM) successfully lobbied the Clinton administration for regulations requiring that the ethanol (ethyl alcohol) used in motor vehicle fuel be produced from corn. Why? Because ADM had a near monopoly on corn-based ethanol production, so the regulation would increase its gains from monopoly power.

Economic Efficiencies: Monopoly v. Perfect Competition

Comment P = MC Minimum point on AC Curve Rent seeking? Cost inflation R&D
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Allocative Efficiency Productive Efficiency Excess profit X-inefficiency Technical progress

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PC v. M PC M X PC M X? (Check) PC M X PC M ? PC ? M ?
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Contestable Markets
Theory developed by William J. Baumol, John Panzar and Robert Willig (1982) Helped to fill important gaps in market structure theory Perfectly contestable market the pure form not common in reality but a benchmark to explain firms behaviours

Contestable Markets
Key characteristics:
Firms behaviour influenced by the threat of new entrants to the industry No barriers to entry or exit No sunk costs Firms may deliberately limit profits made to discourage new entrants entry limit pricing Firms may attempt to erect artificial barriers to entry e.g

Contestable Markets
Over capacity provides the opportunity to flood the market and drive down price in the event of a threat of entry Aggressive marketing and branding strategies to tighten up the market Potential for predatory or destroyer pricing Find ways of reducing costs and increasing efficiency to gain competitive advantage

Contestable Markets
Hit and Run tactics enter the industry, take the profit and get out quickly (possible because of the freedom of entry and exit) Cream-skimming identifying parts of the market that are high in value added and exploiting those markets

Contestable Markets
Examples of markets exhibiting contestability characteristics:
Financial services Airlines especially flights on domestic routes Computer industry ISPs, software, web development Energy supplies The postal service?

Market Structures

Cautioned!!
Models can be used as a comparison they are not necessarily meant to BE reality! When looking at real world examples, focus on the behaviour of the firm in relation to what the model predicts would happen that gives the basis for analysis and evaluation of the real world situation. Regulation or the threat of regulation may well affect the way a firm behaves. Remember that these models are based on certain assumptions in the real world some of these assumptions may not be valid, this allows us to draw comparisons and contrasts. The way that governments deal with firms may be based on a general assumption that more competition is better than less!