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