1 Chapter 9: Imperfect Competition Imperfectly competitive firms have some control of price –Long-run economic profits possible –Reduce economic surplus Three types 1.Monopoly has only one seller, no close substitutes 2.Monopolistic competition has many firms with differentiated products These products are all close substitutes 3.Oligopoly is a small number of firms producing close substitutes

2 Monopolistic Competition Number of Firms Many firms PriceLimited flexibility Entry and ExitFree ProductDifferentiated Economic Profits Zero in long run Decisions P, Q, product differentiation Perfect Competition Many firms Price taker Free Standardized Zero in long run Q only

3 Oligopoly Number of Firms Few firms, each large PriceSome flexibility Entry and ExitLarge size firm Product Differentiated or standardized Economic Profits Possible Decisions P, Q, differentiation, advertising Perfect Competition Many firms Price taker Free Standardized Zero in long run Q only

4 Market Power Market power is the firm's ability to raise its price without losing all its sales Any firm facing a downward sloping demand curve –Firm picks P and Q on the demand curve Market power comes from factors that limit competition Quantity Price Imperfectly Competitive Firm D Quantity Price Perfectly Competitive Firm D

5 Five Sources of Market Power 1.Exclusive control over inputs 2.Patents and copyrights 3.Government licenses or franchises 4.Economies of scale (natural monopolies) 5.Network economies

6 Economies of Scale Returns to scale refers to the percentage change in output from a given percentage change in ALL inputs –Long-run idea –Constant returns to scale: doubling all inputs doubles output –Increasing returns to scale: output increases by a greater percentage than the increase in inputs Average costs decrease as output increases Natural monopoly: a monopoly that results from economies of scale

7 Network Economies Network economies occur when the value of the product increases as the number of users increases –VHS format for video tapes, Blu-ray for DVDs –Telephones –Windows operating system –eBay –Facebook and MySpace

8 Economies of Scale and Start-Up Costs New products can have a large fixed development cost If marginal cost is constant, Marginal cost = Average variable cost Total cost is fixed cost (F) plus variable cost TC = F + (M) (Q) –Total cost increases as output increases Average total cost is ATC = F / Q + M –Average total cost decreases as output increases

9 Economies of Scale Quantity Total cost ($/year) F TC = F + M Q Average cost ($/unit) Quantity ATC = F/Q + M M

10 Video Game – Different Volumes NintendoPlaystation Annual Production (000s) 1,0001,200 Fixed Cost ($000s)$200 Variable Cost ($000s)$800$960 Total Cost ($000s)$1,000$1,160 ATC per game$1.00$0.97

11 Video Games – Different Production Levels NintendoPlaystation Annual Production (000s) 5001,700 Fixed Cost ($000s)$10,000 Variable Cost ($000s)$100$340 Total Cost ($000s)$10,100$10,240 ATC per game$20.20$6.08

Market Power – Economies of Scale 12 Intel's Advantage Development cost of a new chip$2 billion Marginal cost of making a chipPennies Dominating the marketPriceless Intel supplies more than 80% of the processors for PCs

Monopolist 13 Monopoly Demand and Marginal Revenue Price Quantity a D Q0Q0 Q 0 /2 a/2 MR To sell more, price has to go down; And, a lower price applies to all the units; Marginal revenue is smaller than price ( lies below demand curve).

Monopoly and Profit Maximization A monopolist knows his demand and marginal revenue curves Marginal cost is also known If he operates at P = $3 and Q = 12, MC > MR Decrease output –If the firm operates at Q = 8, then MC = MR = 2 The demand curve sets the price, P = $8 –At any output below 8, MC < MR Price ($/unit of output) Quantity (units/week) 3 MC 2 6 D 12 MR 4 8

Monopoly Losses and Profits Price ($/minute) Minutes (millions/day) ATC Economic loss = $400,000/day D 0.05 MC MR 24 Price ($/minute) Minutes (millions/day) ATC D 0.05 MC MR Economic profit = $400,000/day

The Invisible Hand Fails Quantity (units/week) The socially optimal amount occurs where MC = MB, Q = 12 units and P = $3 The monopolist's optimal amount occurs where MC = MR, Q = 8 units and P = $4 2 MR D Marginal Cost

Monopoly and Perfect Competition

Price Discrimination 18 Price discrimination means charging different buyers different prices for essentially the same good or service –Separate the groups –No side trades among buyers Many forms of price discrimination –Hurdle method: discounts for identifiable groups (e. g., students, AARP) –Perfect discrimination: negotiate separate deals with each customer

An Example: Carla the Editor Opportunity cost of Carla's time is $29 Student Reservation Price A$40 B38 C36 D34 E32 F30 G28 Total Revenue $40 $76 $108 $136 $160 $180 $196 MR $40 $36 $32 $28 $24 $20 $16

Carla Offers a Rebate  If reservation price < $36, mail in rebate Student Reservation Price Total Revenue A$40 B38 76 C MR $ Discounted Price Submarket D$34 E3264 F3090 MR $

Carla's Choices Program Social Optimum Papers Edited6 Price$30 Total Revenue$180 Carla's Time $174 Economic Profit$6 Total Surplus$36 Single Price 3 $36 $108 $87 $21 $27 Perfect Discriminator 6 Reservation $210 $174 $36 Hurdle 5 = (3 + 2) $36, $4 rebate $172 $145 $27 $35

Hurdle Method of Price Discrimination The hurdle method of price discrimination is the practice of offering a discount to all buyers who overcome some obstacle. –Temporary Sales –Hard cover and paperback books –Multiple car models from one manufacturer –Commercial air carriers –Movie producers and phased releases –Scratch and Dent appliance sales