Foundation of Economic Analysis 3250:600 Instructor: Richard W. Stratton Meets: Thursday 5:20 – 7:50 pm CAS 134

The University of Akron Administration This Week’s Assignments Farnham Chapter 8 (Monopoly) Farnham Chapter 9 (Oligopoly) Essay 1 Next Week’s Assignments Test 2 2/27/2019 The University of Akron Decision Tree

Monopoly Monopolistic competition Oligopoly Decision Tree Monopoly Monopolistic competition Oligopoly

Market Structure - summary Common behavior Firms estimate marginal costs and marginal revenues and then try to sell all units of output for which expected MR > expected MC Price takers The price out of control of firm: P = MR Thus they only need to determine the level of output for which MC = P = MR Price seekers (makers) Firms have some market power and choice in the price they charge. Thus they try to set prices that enable them to sell all units of output for which expected MR > expected MC 2/27/2019 The University of Akron

Decision Tree Description Monopoly model Comparison to perfect competition Market power

Description – Market Structure 2/27/2019 The University of Akron Decision Tree

Description - Monopoly Market power: ability of a firm to influence the prices of its products and develop strategies to earn profits over longer periods of time Monopoly: single firm producing product with no close substitutes Price-searchers: firms in imperfect competition 2/27/2019 The University of Akron Decision Tree

Description - Monopoly One firm Firm is the market supplier Selling unique product No or very poor substitutes Barriers to entry Potential competitors face substantial barriers (costs) of entry 2/27/2019 The University of Akron Decision Tree

Description - Monopoly Monopoly Firm Behavior Continue to assume profit maximization Profit = Total Revenue – Total Cost P = TR – TC Same profit maximization rule MR = MC 2/27/2019 The University of Akron Decision Tree

Description - Monopoly Remember that perfectly competitive firms face a perfectly elastic demand curve, at the market equilibrium price What demand curve does the monopoly firm face? The market demand! 2/27/2019 The University of Akron Decision Tree

Description - Monopoly If firm faces the market demand, What impact on the firm’s revenue function? To sell more output, the firm must lower its price Thus the firm’s revenue function is NOT a straight line 2/27/2019 The University of Akron Decision Tree

The University of Akron Monopoly Model Q = 80 - 6P 2/27/2019 The University of Akron Decision Tree

The University of Akron Monopoly Model AR MR 2/27/2019 The University of Akron

The University of Akron Monopoly Model Can you identify the elasticity of this market demand? Elastic Inelastic AR MR Unit Elastic 2/27/2019 The University of Akron

The University of Akron Monopoly Model At what output level is TR maximized? What is MR at this level of output? AR MR TR 2/27/2019 The University of Akron

Monopoly Model, SR profit Firm Behavior Firms maximize profits Profit = Total Revenue – Total Cost P = TR – TC 2/27/2019 The University of Akron Decision Tree

Monopoly Model, SR profit TC Profit = TR - TC At what level of output is profit max? So let’s use MC=MR! $ ? TR Q* Q 2/27/2019 The University of Akron Decision Tree

Monopoly Model, SR profit Profit = TR - TC At what level of output is profit max? Price? MC AR MR 2/27/2019 The University of Akron

Monopoly Model, SR profit Profit maximizing output level? Price? Figure 8.1a $ D MR MC A PM B QM Q 2/27/2019 The University of Akron

Monopoly Model, SR profit Is this firm making a profit or loss? Figure 8.1a $ D MR MC A PM ATC B ATCM QM Q 2/27/2019 The University of Akron

Monopoly Model, long run What market adjustments will be made in the long run? Since there are barriers to entry, the firm can continue to operate at a profit 2/27/2019 The University of Akron Decision Tree

Monopoly Model, SR profit Is this firm making a profit or loss? Figure 8.1a $ D MR MC ATC B ATCM PM A QM Q 2/27/2019 The University of Akron

Monopoly Model, long run What market adjustments will be made in the long run? This firm is making a loss It will operate in SR if P>AVC It will shut down in the LR, unless demand increases 2/27/2019 The University of Akron Decision Tree

Comparison Monopoly & PC Perfect Competition Monopoly MR = MC P = MR P > MR; P > MC Supply =>MC Supply is a single P,Q combination LR: P = ATC; P = 0 LR: P > ATC; P > 0 LR: ATC minimized Firms may have other objectives LR: P = min. ATC 2/27/2019 The University of Akron

Comparison Monopoly & PC Perfect Competition Monopoly Lots of small firms may have high minimum ATC Economies of scale may allow monopolist to offer good at lower cost than competitive market P = 0 implies no funds for research and development P > 0 may be source of research and innovation 2/27/2019 The University of Akron

The University of Akron Market Power Sources Limits Measures Antitrust 2/27/2019 The University of Akron

The University of Akron Market Power - sources Barriers to entry Economies of scale Input barriers Government created Brand loyalties Consumer lock-in Network externalities 2/27/2019 The University of Akron

The University of Akron Market Power - sources Economies of scale Firms which find MES have cost advantage Mergers can eliminate rivals Input barriers Ownership of key input 2/27/2019 The University of Akron

The University of Akron Market Power - sources Government created Licenses, copyrights, patents Franchises – utilities, cable TV, etc. Brand loyalties Consumers perceived differences 2/27/2019 The University of Akron

The University of Akron Market Power - sources Consumer lock-in Contractual commitments - Cell phones Durable goods - Computer management systems; database Specific training Network externalities Industry standards – usefulness depends on extent of users 2/27/2019 The University of Akron

The University of Akron Market Power - limits Consumer demand Own price elasticity of demand Limits the price monopolies can charge Potential competition Cost of overcoming barriers Fear of regulation If consumers protest to government Dynamic nature of market power 2/27/2019 The University of Akron

Market Power - measures Price-cost margin (Lerner Index) L = (P – MC) / P Concentration ratio Four-firm (8-firm) ratio (Sale4/TotalSale) Cross-price elasticity Can be used to determine the extent of the relevant market 2/27/2019 The University of Akron

Market Power - measures Herfindahl-Hirschman Index S = market share 0 < HHI < 10,000 Justice department threshold Increase index by 200 points and beyond 1000 2/27/2019 The University of Akron

Market Power – and antitrust Government (FTC) approval needed for some mergers Government enforcement of rules against monopoly practices Regulation of monopolies How to set price, but we have no time 2/27/2019 The University of Akron

Market Power – other issues Regulation of monopolies How to set price Price discrimination Can firm sell output at different prices to different customers? 2/27/2019 The University of Akron

Monopoly Monopolistic competition Oligopoly Decision Tree Monopoly Monopolistic competition Oligopoly

Description – Market Structure 2/27/2019 The University of Akron Decision Tree

Monopolist competition Key feature is product differentiation Perceived (may not be real) Many close substitutes Thus the firm’s demand function is highly elastic, but NOT perfectly elastic Examples of differentiation Design (clothes) Services Brand Location Qualtity 2/27/2019 The University of Akron

Monopolist competition Firm’s demand is downward sloping Lower price relative to competitors Own customers buy more Increase market share Higher price relative to competitors Own customers buy less Decrease market share However, low barriers to entry constrains profits 2/27/2019 The University of Akron

Monopolist competition, SR profit Is this firm making a profit or loss? Figure 8.4 $ D MR MC ATC P ATC Qmc Q 2/27/2019 The University of Akron

Monopolist competition Short run profits entice firms to enter the market Each firm’s market share decreases Deducing demand, but increasing elasticity Reducing profits When will firms stop entering the market? 2/27/2019 The University of Akron

Monopolist competition, LR profit As firms enter the market Figure 8.4 $ MC D MR ATC P = ATC Qmc Q 2/27/2019 The University of Akron

Monopolistic Competition & PC Perfect Competition Monopolistic Competition P = MR = MC P > MR = MC LR: P = ATC; P = 0 LR: P = ATC; P = 0, marginal firm LR: ATC minimized LR: P = min. ATC LR: P = ATC above minimum; Excess capacity Market output less than PC Product variety Advertising costs > 0 2/27/2019 The University of Akron

Monopoly Monopolistic competition Oligopoly Decision Tree Monopoly Monopolistic competition Oligopoly

Description – Market Structure 2/27/2019 The University of Akron Decision Tree

Description - Oligopoly Oligopoly can be caused by the same market power factors as monopoly Economies of scale Input barriers Mergers 2/27/2019 The University of Akron

Description - Oligopoly Key features Few firms Barriers to entry Firm interdependence The actions of one firm impacts the actions of other firms 2/27/2019 The University of Akron

Description - Oligopoly Firm interdependence The actions of one firm impacts the actions of other firms This causes modeling problems This is the only market structure which requires manager to anticipate rivals’ responses to their decisions 2/27/2019 The University of Akron

Description - Oligopoly Since there are many possible responses, there is no one model to fit all circumstances Different models may be appropriate in different situations Each has different behavioral assumptions Non-cooperative models Rivals compete Cooperative models Rivals try to act as monopoly 2/27/2019 The University of Akron

The University of Akron Oligopoly models Non-cooperative models Kinked demand Maintain market share Game theory Strategic behavior Strategic entry deterrence Keeping competitors out Predatory Pricing Drive competitors out of market 2/27/2019 The University of Akron

The University of Akron Oligopoly models Cooperative models Cartel Joint profit maximization (monopoly) Tacit collusion Price leadership 2/27/2019 The University of Akron

The University of Akron Oligopoly & PC Perfect Competition Oligopoly MR = MC P = MR P > MR; P > MC LR: P = ATC; P = 0 LR: P > ATC; P > 0 LR: ATC minimized LR: P = ATC above minimum; Excess capacity LR: P = min. ATC Firms may have other objectives 2/27/2019 The University of Akron

The University of Akron Oligopoly & PC Perfect Competition Oligopoly Market output less than PC Advertising costs > 0 Product variety possible Concentrated economic and political power may not be desirable 2/27/2019 The University of Akron

The University of Akron Oligopoly models - LR Contestable markets If barriers of entry can be reduced, potential entrants can keep profits low Improve efficiency Notice role of international trade in this process 2/27/2019 The University of Akron

Market Structure - summary Common behavior Firms estimate marginal costs and marginal revenues and then try to sell all units of output for which expected MR > expected MC Price takers The price out of control of firm: P = MR Thus they only need to determine the level of output for which MC = P = MR Price seekers (makers) Firms have some market power and choice in the price they charge. Thus they try to set prices that enable them to sell all units of output for which expected MR > expected MC 2/27/2019 The University of Akron

Monopoly Monopolistic competition Oligopoly Decision Tree Monopoly Monopolistic competition Oligopoly