Principles of Economics Imperfect competition: Monopoly, Oligopoly and Monopolistic competition

Perfect competition on a product market Imperfect competition Demand Horizontal (p = constant) Downward sloping (p(q)) Product Homogeneous Heterogeneous Information Perfect Imperfect Profit Zero profit Extra profit Number of sellers Many One or few Price formation Price takers Price makers Disadvantages: Smaller total surplus of the economy Smaller quantity on the market Advantages: Technological progress (Schumpeter says innovations overpower negative effect of smaller total surplus – SCHUMPETER HYPOTHESIS) Economies of scale

Market power Market power is analyzed using several indicators: Share of 4 biggest companies on the market Herfindahl-Hirschmann index: where S is a percentage share of each company on the market. In monopoly HHI = 10000, in perfect competition 0. If HHI > 1800 concentration is high, if HHI < 1000 concentration is low and for 1000<HHI<1800 concentration is medium.

Dead weight loss Imperfect competition causes total surplus decline – DEAD WEIGHT LOSS – it is a difference between total surplus in perfect competition (p = MC) and imperfect equilibrium (MR = MC)

Monopoly Properties: 1 seller, no substitutes. Monopolist can change price. There are barriers for entry (patents, copyright, large starting investment) In perfect competition demand is horizontal (p = MR), in monopoly demand is falling (MR < p) Monopolist maximizes profit: MC = MR < p (in real life p = AC + margin

P MC M AC DWL P = AR MR Q

Total revenue (TR) and marginal revenue (MR) TR = p×q AR = p×q/q = p MR = ΔTR/ Δq When demand is falling TR has bell-like form TR reaches its maximum when │Ed│ = 1 Note that MR and demand are not the same curve as in perfect competition TR p = AR MR Q P │Ed │ = 1 │Ed │ < 1 │Ed │ > 1 elastic inelastic

Exercise 1 Total cost function of a company is TC=40+2Q and demand function is P=10-0,1Q. If TC=120, what is the monopolist’s profit?

TC=40+2Q 120=40+2Q Q=40 P=10-0,1Q=10-0,1*40=6 Π=TR-TC=P*Q-TC=240-(40+2*40) Π=240-120=120

Exercise 2: Demand function is Q=200-10P. Marginal revenue is MR=20-0.2Q, average costs are AC=0,05Q+5+225/Q and marginal costs MC=5+0,1Q. Find optimum price, production and profit of this monopolist.

Π=TR-TC=P*Q-AC*Q=15*50-(0,05*50+5+225/50)*50=750-600=150 MR=MC 20-0,2Q=5+0,1Q Q=50 Q=200-10P P=15 Π=TR-TC=P*Q-AC*Q=15*50-(0,05*50+5+225/50)*50=750-600=150

Exercise 3 Demand is p = 32 – 2q. Find total revenue function. When it reaches its maximum? Answer: TR = (32 – 2q)q = -2q2 +32q TR is at its maximum when Ed = -1, which is exactly at the half-point of a linear demand: 32 – 2q = 0 Q = 16, half-point: q = 8 TR(8) = -128 + 256 = 128

Oligopoly Oligopoly is a market structure where there are only few sellers and many buyers. Demand is falling Sellers can affect price, but les than monopolist. This interaction is analyzed using game theory Oligopolist used to compete with prices, today with promotion and differentiation Pure oligopolies (homogeneous product) and differentiated oligopolies Duopoly: the simplest oligopoly (only two players) Price is greater than in perfect competition, smaller than monopolistic price

Game theory Players choose between options Depending on decision of others they have different outcomes (profits) John Nash won a Nobel prize for analysis of game theory Nash Equilibrium: nobody can improve its position without change in the opponents decision Dominant strategy: a company chooses 1 option no matter what the other does Maximin strategy: traditional (risk averse) strategy Simultaneous or sequential games Maximin strategy: (100, 100) Nash equilibria: blue No dominant strategy If A has advantage: (400, 100) If B has advantage: (300, 350) Cooperative strategy: (300, 350) Company B Cheap product Quality product Company A 100 350 300 320 50 400

Exercise 4 Air transport compaines’ shares in the USA in 1986 are given with the following table: a) Find C4 concentration ratio. b) Find HHI indeks (be careful – “the others” should not be put into the index)

a) C4 = P1+P2+P3+P4 Shares should be sorted from biggest to smallest! Four major air transport companies account for 55% of the American airlines market.

b) HHI = P12 + P22 + … Pn2 HHI = 172+152+122+122+92+82+72 HHI = 967 out of 10000 => Low concentration

Monopolistic competition Many sellers, no barriers for entry Differentiated product In the short run companies behave like monopolists and earn extra profit In the long run newcomers offer substitutes => demand declines, profits fall to zero (p = AC)

Short run equilibrium in monopolistic competition Equilibrium similar to monopolistic (MR = MC) Extra profit (grey). MC M AC DWL P = AR MR Q

Long run equilibrium in monopolistic competition In the long run demand becomes more elastic because of the new companies MR = MC, P = AC (no profit) Monopolistic equilibrium (M) worse than perfectly competitive (E) because consumers pay more for less goods in mon.comp. MC AC M DWL E P = AR MR Q

Exercise 5 Monopolistically competitive company maximizes profit at TR=40 Its marginal revenue is MR=10 and MC=6+0.5Q. If it maximizes profit, what is the optimal price, quantity and MC? If it is a long-run equilibrium what is the value of total cost?

MR=MC 10=6+0,5Q Q=8 TR=P*Q 40=P*8 P=5 TC = 40 since in the long run profits are zero

Risk and uncertainty Speculation is the activity of moving goods from places and times of abundancy to places and times of scarcity Speculation improves alocation and brings markets to equilibrium Arbitrage is the activity of simulatenous purchase on one market and sale on the other (riskless speculation) Hedging is a process of risk neutralization

Person is RISK AVERSE if loss displeasure is stronger than gain pleasure Person is RISK FRIENDLY if gain pleasure is stronger than loss displeasure Person is RISK NEUTRAL if it regards gains as positive as losses negative. Insurance spreads risk among many insurance contractees (moral hazard – insurance fraud)

Exercise 6 Discuss individuals’ position towards risk: Agatha would pay 1000$ for the insurance from loss of 10000$ that occurs in 5% of the cases. Ben would pay no more than 1000$ for the insurance from loss of 10000$ that occurs in 20% of the cases. Max would pay 1000$ for the insurance from loss of 10000$ that occurs in 10% of the cases. Agatha: averse, Ben: friendly, Max: neutral