Lecture 3: Imperfectly Competitive Markets Required Text: Chapter 2 Market Models

Monopoly When there many buyer of a good with no close substitutes but only one seller, the market is called a monopoly. Bt cotton (of Monsanto) Windows (of Microsoft Corporation) The extent of monopoly hinges crucially on whether there are close substitutes available KFC sells a unique type of chicken with 11 herbs and spices Still KFC is not a monopoly, because there are many other restaurants selling similar fried chicken Due to competitors, KFC cannot set any price it wants

Monopoly A monopolist faces a downward sloping demand curve (i.e., the market demand) Since a monopolist is the only seller of the good, it can set whatever price it wants – price setter The monopolist faces a trade-off though – the higher the price it charges, the less consumers will buy The monopolist sets the price that maximizes its profits Profit maximizing condition: MR = MC A monopolist sells the quantity where MR and MC curves intersect The monopolist sets a price corresponding to that optimal production point on the market demand curve

Monopoly Price and Output

Monopoly A monopolist faces a downward sloping marginal revenue curve, which always lies underneath the demand curve. Because, the monopolist has to lower the price to sell an additional unit of the good – lowers price to increase output A Monopolist operates on the elastic portion of the demand curve A monopolist do not have a supply curve, because there is no “going price.”

Sources of Monopoly Power Natural monopoly Industry where AC curve decreasing at the point where crosses market demand Industry survives only if monopolized Patents Ex. photography Resource monopolies Single firm controls productive input Legal barriers to entry

Natural Monopoly

Price Discrimination Charging different prices for identical items Ability to prevent resell of low-price units First-degree Price Discrimination Charging different customers different prices (as the customers are most willing to pay) for an identical good Second-degree Price Discrimination Charging same customer different prices for different unit of the same good Third-degree Price Discrimination Charging different prices for the same good in different markets

Third-degree Price Discrimination Charging different prices in different markets Groups of consumers identifiable Different downward sloping demand curve Producer profit Production of goods where MR same in both markets and equal to MC More elastic demand group receives lower price

Third-Degree Price Discrimination by a Monopolist in Two Markets

Two-Part Tariffs Entry fee allows purchase of goods or services Meaning of tariff Customers are charged maximum willingness to pay Measure consumer’s surplus Charge competitive price as long as no difference in consumers Charge low initial fee and high usage fee

Pricing Strategy with a Two-Part Tariff

Monopsony When there many seller of a good with no close substitutes but only one buyer, the market is called a monopsony. College athletes – NCAA Even though college athletes have their choice of schools to attend, the NCAA limits the compensation they can receive. In a sense al college athletes work for the NCAA, and the NCAA has complete control over the prices paid to the athletes. A monopsonist is a consumer – it is the only consumer. It seeks to maximize its consumer surplus

Monopsony A monopolist faces a upward sloping supply curve (i.e., the market supply) Since a monopsonist is the only buyer of the good, it can set whatever price it wants – price setter The monopsonist faces a trade-off though – the lower the price it pays, the less sellers will sell The monopsonist sets the price that maximizes its profits Profit maximizing condition: MV = ME A monopsonist purchases the quantity where marginal expenditure (ME) and marginal value (MV) curves intersect The monopsonist pays a price corresponding to that optimal consumption point on the market supply curve

Monopsony A monopsonist’s marginal value or demand curve is downward sloping. A monopsonist’s marginal expenditure curve is upward sloping, which always lies above the marginal cost (supply) curve. Because, the monopsonist has to raise the price to purchase an additional unit of the good – increases price to increase consumption A Monopolist operates on the elastic portion of the demand curve

Monopsony Equilibrium ME MC = Supply Curve P MV = Demand Curve Q

Monopolistic Competition (Differentiated Competition) When a market consists of many firms, each competing to sell a different variety of a product or service, each variety being different in some way but a close substitute for one another, the market is called a monopolistic competition. Hamburgers sold by McDonalds, Burger King, Wendy’s, etc. Soda, candy, fast food, etc. Each firm produces a differentiated good, which is not imitated perfectly by any other firm. However, other firms produces varieties that are close substitutes. Since each firm sells a unique variety of a product, each firm is like a “small monopoly.” Each firm can set any price for that variety – monopoly market power.

Monopolistic Competition (Differentiated Competition) Like a monopoly, a monopolistic firm faces a downward sloping marginal revenue (MR) curve, that lies below the demand curve it faces, and maximizes its profits by producing where MR=MC. MC = Supply Curve (firm) P MV = Demand Curve (firm) MR (firm) Q

Monopolistic Competition (Differentiated Competition) Since each firm produces a differentiated good, there is a single marginal value (demand) curve for each variety, and single marginal cost (supply) curve for each variety. In a monopolistic competition, there is so much competition among the many sellers of a differentiated product that the price results often appear similar to those of a perfect competition. Unlike a real monopoly there is free entry and exit of other firms that produce close substitutes. Each time a new firm enters with its own variety, the demand curve for all other firms falls. The greater the variety, the less each consumer is willing to pay for any single variety.

Monopolistic Competition (Differentiated Competition) Each time a new firm enters with its own variety, the demand curve for all other firms falls – that is the market share of other firms falls. MC = Supply Curve (firm) P MV = Demand Curve (firm) MR (firm) Q

Monopolistic Competition (Differentiated Competition) Whenever producer surplus per firm is greater than fixed costs, new firms will enter the market with new varieties, decreasing the demand curve facing all firms. Similarly, when producer surplus per firm is less than fixed costs, some firms will begin to leave the market. As firms enter and exit the market, they will eventually settle on an equilibrium where economic profits are zero. At zero economic profits, each firm is making just as much money it could in their next best alternative. Producer surplus per firm equals the fixed cost for the firm – firms are indifferent between producing or not.

Oligopoly When there only a few sellers of a product or service and many buyers, the market is called an oligopoly. There are only a few sellers of credit cards – Visa, MasterCard, Discover, and American Express. Anheiser-Busch, Miller, and coors collectively sell 90% of all beers purchased in the US The soda market is dominated by Coca-Cola and Pepsi Five beef packing firms sell 80% of all beef processed in the US. Oligopolies can exist for a number of reasons Economies of scale – to produce a good at low per unit cost, you need to “get big.” Limited demand for any one product – once the market is saturated by a few big firms, entering the market would not be profitable.

Oligopoly The price that results from an oligopoly follows no simple formula – the reason is that oligopoly firms engage in strategic behavior. When Pepsi increases its advertising, so does Coca-Cola. Firms in an oligopoly have incentives to both collude and compete. Tacit Collusion: Sometimes, without explicit planning oligopoly firms charge similar high prices, which are close to the monopoly price. Unsolicited understanding that both will keep their prices high. Neither reduces it’s price, because it is scared that the other firms will retaliate with a price reduction in turn – price war.

Oligopoly Tacit collusion usually occurs through price leadership – where one firm announces a price and all other firms respond with similar price. Price Warfare: Sometimes, oligopoly firms engage in price war that leads to low prices close to that of perfect competition. Airline tickets – there are only a few airlines, but every airline struggles to avoid bankruptcy. Soups in grocery stores are not expensive – there are only a few vendors. Because of collusion or competition, price can be low or high in oligopolies. Oligopoly price lies somewhere in between the monopoly and perfect competition prices.

Oligopsony When there only a few buyers of a good or service and many sellers, the market is called an oligopsony. There are thousands of cattle producers (ranches and feedlots) throughout the midwest, yet there are only few firms (beef packers) who purchase cattle. These cattle buyers have the power to depress prices, if they collude with one another to keep price down – monopsony power. However, the buyers also compete with one another for a limited supply of cattle raising the purchase price – price warfare – competition. Since both elements of collusion and competition are present in oligopsony, price can be low or high. Oligoposony price lies somewhere in between the perfect competition and monopsony prices.

Market Models Compared Attributes Perfect Competition Monopolistic Competition Oligopoly (seller) Oligopsony (buyer) Monopoly (seller) Monopsony (buyer) Product Homogenous Differentiated Homogenous or differentiated Number of Firms Many Few One Entry Easy Fairly Easy Difficult Very difficult to impossible Market Strategies Timing and volume of sales Set price, brand names, promotion, product design, and packaging Set price, if differentiated then establish brand name, promotion, product design, and packaging Set price based on MR=MC