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PRINCIPLES OF ECONOMICS MARKET MODEL – FROM PERFECT COMPETITION TO MONOPOLY
PART III: MONOPOLISTIC COMPETITION AND OLIGOPOLY
Theory of Monopolistic Competition • A monopolistically competitive industry has the following characteristics: – A large number of firms – Product differentiation Differences; brand, packaging, location, salespeople, etc – No barriers to entry
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Monopolistic Competitor’s Demand Curve
• Elasticity of demand for its product is extremely high (endless substitutes for the goods produced, due to large number of firm) • Monopolistic firm has practically no rival due to product uniqueness. So, elasticity of demand for product low. So demand curve is downward sloping. • Demand curve in between perfect competition and monopoly.
Relationship Between Price and Marginal Revenue for a Monopolistic Competitor • Because of downward sloping demand curve, a firm in this market has to sell an additional unit of its good at a lower price. • So like in monopoly, P>MR.
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Output, Price, and Marginal Cost for the Monopolistic Competitor • A firm in this market is the same as both the perfectly competitive AND the monopoly in one regard: it produces the quantity of output at which MR=MC, and charges the highest price it can charge.
Output, Price, and Marginal Cost for the Monopolistic Competitor • For the monopolistic competitor, P>MR. • Since Q produced is at MC=MR, then it means it must produce a level of output at which P is bigger than MC.
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Profits in the Long Run? • Most likely, no. As easy entry and exit to market will result in the same thing as in perfect competition market. • But it can happen if the firm differentiate its product sufficiently. • Firms that try to differentiate their products from those other sellers in ways other than price are said to be engaged in nonprice competition.
Excess Capacity Theorem • The theory of monopolistic competition makes one major prediction for this market, that is referred to as “excess capacity theorem”: “ a monopolistic competitor in equilibrium produces and output smaller than the one that would minimise its cost of production”
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Excess Capacity Theorem • States that a monopolistic competitor in equilibrium produces an output smaller than the one that would minimize its costs of production. • The perfectly competitive firm produces a quantity of output consistent with lowest unit costs. The monopolistic competitor does not. • The monopolistic competitor is said to underutilize its plant size or to have excess capacity
A Comparison of Perfect Competition and Monopolistic Competition: The Issue of Excess Capacity
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Excess Capacity Theorem • In summary; the monopolistic competitor operates at excess capacity as a consequence of its downward-sloping demand curve, and its downward-sloping demand curve.
A Comparison of Perfect Competition and Monopolistic Competition: The Issue of Excess Capacity
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A Comparison of Perfect Competition and Monopolistic Competition: The Issue of Excess Capacity • The monopolistic competitor operates at excess capacity as a consequence of its downward-sloping demand curve. • Its downward-sloping demand curve is a consequence of differentiated products (a case for advertising).
Self Test Questions 1. How is a monopolistic competitor like a monopolist? How is it like a perfect competitor? •
•
A monopolistic competitor is like a monopolist in that it faces a downward-sloping demand curve; it is a price searcher, P > MR; and it is not resource allocative efficient. It is like a perfect competitor in that it sells to many buyers and competes with many sellers, and there is easy entry into and exit from the market.
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Self Test Questions • 2. Why do monopolistic competitors operate at excess capacity? •
Essentially, monopolistic competitors face downward sloping demand curves. Because the demand curve is downward sloping, it cannot be tangent to the lowest point on a U-shaped ATC curve
Monopolistic Competitor and 2 types of Efficiency • A firm is RESOURCE ALLOCATIVE EFFICIENT if it charges a price that is equal to marginal cost, P=MC. • So, since a monopolistic competitive firm charges a price that is greater than marginal cost, P>MC, then it is NOT resource allocative efficient. • A firm is PRODUCTIVE EFFICIENT if it charges a price that is equal to its lowest ATC. Because a monopolistic competitive firm operates at excess capacity, it is NOT productive efficient.
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OLIGOPOLY: ASSUMPTIONS AND REAL WORLD BEHAVIOUR • A theory of market structure based on three assumptions:
There are few sellers and many buyers. Firms produce and sell either homogeneous or differentiated products. There are significant barriers to entry.
OLIGOPOLY: ASSUMPTIONS AND REAL WORLD BEHAVIOUR • The oligopolist is a price searcher. • It produces the quantity of output at which MR = MC.
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Concentration Ratio • Used to define oligopolistic market structure. • The percentage of industry sales (or assets, output, labor force, or some other factor) accounted for by x number of firms in the industry. • The “x number” in the definition is usually 4 or 8, but it can be any number (although it is usually small. Four-Firm Concentration Ratio: CR4 = Percentage of industry sales accounted for by four largest firms Eight-Firm Concentration Ratio: CR8 = Percentage of industry sales accounted for by eight largest firms
Concentration Ratio • High concentration ratio implies that few sellers make up the industry. A low CR implies that more than a few sellers make up the industry. • E.g: CR4 for industry Z. Total industry sales for a given year are RM5M. The four largest firms in the industry account for RM4.5M in sales. So the CR4 would be 0.90 or 90%. •Eight-Firm Concentration Ratio: CR8 = Percentage of industry sales accounted for by eight largest firms •Industries with high CR4 and CR8 in recent years include cigarrates, cars, tires, cereal breakfast food, etc
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Price and Output Under 3 Oligopoly Theories • Cartel Theory - oligopolistic firms act as if there were only one firm in the industry. • Kinked Demand Curve Theory - assumes that if a single firm in the industry cuts prices, other firms will do likewise, but if it raises price, other firms will not follow suit. The theory predicts price stickiness or rigidity. • Price Leadership Theory - the dominant firm in the industry determines price, and all other firms take their price as given.
Cartel Theory • Cartel Theory - oligopolistic firms act as if there were only one firm in the industry. • Cartel: An organization of firms that reduces output and increases price in an effort to increase joint profits. • A cartel is formed to reap the benefits that would exist for a monopolist.
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The Benefits of a Cartel (to Cartel Members) We assume the industry is in long-run competitive equilibrium, producing Q1 and charging P1. There are no profits. (P=MC) A reduction in output to QC through the formation of a cartel raises prices to PC and brings profits of CPCAB.
Problems Associated with Cartels •
• • –
– – –
No cartel, no profit. With a cartel, profits are earned. So, the firms have an incentive to form a cartel and to behave cooperatively rather than competitively. But there are problems … the problem of forming the cartel; costly, resistance to bear the cost of forming the cartel, the problem of formulating policy; hard to reach agreement among members. E.g. How much Q reduction. the problem of entry into the industry; as high profits provide an incentive for other firms to join in the industry, the problem of cheating, i.i. increasing the Q without reducing the price.
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The Benefits of Cheating on the Cartel Agreement • The situation for a representative firm of a cartel: in long-run competitive equilibrium, it produces q1 and charges P1, earning zero economic profits. • As a consequence of the cartel agreement, it reduces output to qC and charges PC. • Its profits are the area CPCAB. • If it cheats on the cartel agreement and others do not, the firm will increase output to qCC and reap profits of FPCDE.
The Benefits of Cheating on the Cartel Agreement
Note, however, that if this firm can cheat on the cartel agreement, so can others. Given the monetary benefits gained by cheating, it is likely that the cartel will exist for only a short time.
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Kinked Demand Curve Theory
A theory of oligopoly that assumes that if a single firm in the industry cuts prices, other firms will do likewise, but if it raises the price, other firms will not follow suit. The theory predicts price stickiness or rigidity.
Kinked Demand Curve Theory Example: • Current price charged by firm $25 • If it raises its price to $27, other firms will not match it. So, the firm’s sales will drop from (from 20 – 10) • So the demand curve for the firm above $25 is highly elastic.
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Kinked Demand Curve Theory Example: • However, if the firm lower the price to $23, other firms will match it. • So, the firm’s sales will not increase by much (20-22) • Demand is much less elastic below $25 than above it.
Kinked Demand Curve Theory Conclusion; • There is a kink in the firm’s demand curve at the current price (K). • The kink signifies that other firms respond radically differently to a single firm’s price hikes than to its price cuts.
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Kinked Demand Curve Theory • In this theory, there are 2 demand curves and 2 MR. • The relevant portions of each demand curve are indicated by heavy lines.
Kinked Demand Curve Theory • When considering price cuts, the firm believes it faces d2, the more inelastic demand curve, d2, and the corresponding MR2 curve. • When considering price hike, the firm believes it faces d2, the more inelastic demand curve, d1, and the corresponding MR1 curve. • So a firm have both demand curve d1 and d2, and MR curves MR1 and MR2 due to the kinked demand theory
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• MR curve directly below the kink drop sharply. • MR can be viewed as 3 segments: A-B, gap between B-C, and from C onward. • Gap between B-C= sharp change in MR that occurs when price is lowered. The gap explains why prices might be less flexible (more rigid) in oligopoly than in other market structure.
• Oligopolistic firm produces the output at MR=MC. • For the firm in discussion, MC can change between points B and C, and the firm will continue to produce the same Q and charge the same price. • In other words, prices are ‘sticky’ if oligopolistic firms face kinked demand curves.
Price Rigidity
Price Rigidity
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Price Rigidity • Costs can change within certain limits, and such firms will not change their prices because they expect that none of their competitors will follow their price hikes, but all will match their price cuts. • The theory predicts that changes in marginal costs between B and C will not cause changes in price or output.
Price Leadership Theory The dominant firm in the industry determines price and all other firms take their price as given Key behavioral assumption: • One firm in the industry (the dominant firm) determines price. • All other firms (fringe) take this price as given. • The dominant firm set the price that maximises its profits, and all other firms take this price as given. • All other firms, as price takers, will equate price with their respective MC. • The dominant firm sets the price BASED on information it has about other firms in the industry, as shown in the following figures.
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Price Leadership Theory
• Part (a). The market demand curve and the horizontal sum of the marginal cost curves of the fringe firms are shown. Since fringe firms are price takers, the MC is their supply curve. At P1, the fringe firms supply the entire market (a). • The dominant firm observes that at a price of P1, the fringe firms alone can supply the entire market. • P1 and Q1 define the situation in the industry or market that EXCLUDES the dominant firm.
Price Leadership Theory
• Now add the dominant firm. It’s demand curve=DDN, obtained by observing how much is left for it to supply at each given price. • Example: for P1 the fringe firms would supply for the entire market, NOTHING for the dominant firm to supply. So P1 and Q=0 is one point on the dominant’s firm demand curve as in (b). • The dominant firm continues to locate other points on its demand curve by noting the difference between the market demand curve (D) and MC(F) at each price below P1
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Price Leadership Theory
• The dominant firm produces qDN (where MRDN = MCDN) and charges PDN. • PDN becomes the price that the fringe firms take. They equate price and marginal cost and produce qF in (a). The remainder of the output—the difference between Q2 and qF —is produced by the dominant firm.
Self Test Questions • 1. “Firms have an incentive to form a cartel, but once it is formed, they have an incentive to cheat.” What, specifically, is the incentive to form the cartel, and what is the incentive to cheat on the cartel? • The incentive in both cases is the same: profit. Firms have an incentive to form a cartel to increase their profits. After the cartel is formed, however, each firm has an incentive to break the cartel to increase its profits even further. If there is no cartel agreement, the firm is earning zero profits. But it can earn even higher profits by cheating on the cartel.
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Self Test Questions • 2. What explains the kink in the kinked demand curve theory of oligopoly? • The kink occurs because the demand curve for an oligopolist is more elastic above the kink than it is below it. The difference in elasticity is based on the assumption that rival (oligopoly) firms will not match a price hike but will match a price decline. Thus, if a given oligopolist raises product price, it is assumed that its quantity demanded will fall a lot, but if it lowers price, its quantity demanded will not rise much.
Self Test Questions • 3. According to the price leadership theory of oligopoly, how does the dominant firm determine what price to charge? • The dominant firm tries to figure out the price that would exist if it were not in the market. If this price is $10, the dominant firm figures out how much it would supply at this price (the answer is zero) and at all prices lower than this. For example, suppose the firm supplies 0 units at $10, 20 units at $9, and 30 units at $8. These, then, are three points on the dominant firm’s demand curve—sometimes called the residual demand curve. Next, the dominant firm produces the level of output at which MR = MC and charges the highest price per unit consistent with this output.
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Game Theory, Oligopoly and Contestable Markets • GAME THEORY: A mathematical technique used to analyze the behavior of decision makers who try to reach an optimal position for themselves through game playing or the use of strategic behavior, are fully aware of the interactive nature of the process at hand, and anticipate the moves of other decision makers.
Game Theory • Of the four market structures, oligopoly is often described as the most difficult to analyze. • Analysis is difficult because of the interdependence among firms in an oligopolistic market • Game theory is used by economist to understand the interdependence of these firms. • Game theory: mathematical technique used to analyze the behaviour of decision makers who 1. Try to reach and optimal position through game playing or use of strategic behaviour 2. Are fully aware of the interactive nature of the process at hand 3. Anticipate the moves of other decision makers.
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Game Theory: Prisoner’s Dilemma • A well-known game in game theory. • Illustrates a case where individually rational behaviour leads to a jointly inefficient outcome. • It has been described this way: “ You do what is best for you, I’ll do what’s best for me, and somehow we end up in a situation that is not best for either of us”
Game Theory: Prisoner’s Dilemma Setting:
• 2 men, Bob and Nathan are arrested and charged with jointly committing a crime. They are put in separate cells so that they cannot communicate with each other. The prosecutor goes to each man separately and says the following; 1. If you confess to the crime, and agree to turn state’s evidence and your accomplice does not confess, I will let you off with a $500 fine. 2. If your accomplice confesses to the crime and agrees to turn state’s evidence and you do not confess, I will fine you $5,000. 3. If both you and your accomplice remain silent and refuse to confess to the crime, I will charge you with a lesser crime, which I can prove you committed, and both you and your accomplice will pay fines of $2,000 4. If both you and your accomplice confess, I will fine each of you $3,000.
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Game Theory Example: Prisoner’s Dilemma
OPTIONS AND CONSEQUENCES • Nathan and Bob each have two choices: confess or not confess. • If both men do not confess, each pays a fine of $2,000 (Box 1). • If Nathan confesses and Bob does not, Nathan gets of with the light fine of $500, and Bob pays the stiff penalty of $5,000 (Box 2) • If Nathan does not confess, and Bob confesses, then Nathan pays the stiff penalty of $5,000 and Bob pays the light fine of $500 (Box 3) • If both men confess, each pays $3,000 (Box 4)
Game Theory Example: Prisoner’s Dilemma
OPTIONS AND CONSEQUENCES • Nathan and Bob each have two choices: confess or not confess. • No matter what Bob does, it is always better for Nathan to confess. • No matter what Nathan does, it is always better for Bob to confess. • Both Nathan and Bob confess and end up in box 4 where each pays a $3,000 fine. • Both men would have been better off had they not confessed. That way they would have ended up in box 1 paying a $2,000 fine.
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Cartels and Prisoner’s Dilemma
• Both firms A and B earn higher profits holding to a (cartel) agreement than not, but each will earn even higher profits if it breaks the agreement while the other firm holds to it. • If cartel formation is a prisoner’s dilemma situation, then its predicted by economists that cartels will be short-lived.
Contestable Market Conditions Are markets contestable? – – – – –
Discussion of market structure: number of sellers. Perfect competition: many sellers Monopoly: Only one Monopolistic competition: Many Oligopoly: A few
• Number of sellers in a market influences the behaviour of the sellers within the market. • What is Contestable Market?
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Contestable Market: The Conditions • There is easy entry into the market and costless exit from the market. • New firms entering the market can produce the product at the same cost as current firms. • Firms exiting the market can easily dispose of their fixed assets by selling them elsewhere.
Contestable Market Conclusions • Even if an industry is composed of a small number of firms, or simply one firm, this is not evidence that the firms perform in a noncompetitive way. They might be extremely competitive if the market they are in is contestable. • Profits can be zero in an industry even if the number of sellers in the industry is small. • If a market is contestable, inefficient producers cannot survive. Cost inefficiencies invite lower cost producers into the market, driving price down to minimum ATC and forcing inefficient firms to change their ways or exit the industry.
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Characteristics and Consequences of Market Structures
End of Lecture Thank You
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