PowerPoint to accompany John Sloman Keith Norris

Purpose of Lecture – Imperfect Competition Explain key differences in firm behaviour and market structure: - Re: Oligopoly compared to Monopolistic Competition. So that analysis and comparison can be performed: Determination of profit maximising price and output (short and long-run); Calculation of normal and supernormal profits (short and long-run); Determination of shut-down points (short and long-run). John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Imperfect Competition Chapter 7 Imperfect Competition

Monopolistic Competition Assumptions of monopolistic competition Large number of firms: (Each has small share of market – so not affecting rival to any great extent); Independence: Each firm makes their decision not worried about its affect on rival; Freedom of entry: Product differentiation: Products & services vary across rivals; Can raise price without losing all customers; Downward sloping demand curve – relatively elastic given large number of competitors consumers can turn to. examples in Australia Petrol stations, hairdressers, restaurants & builders; Many firms in industry but usually only one in a location (retailing, newsagents – local monopoly can charge higher prices) John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Monopolistic Competition Short-Run equilibrium of the firm: - Figure 7.1 (a) same for monopoly except AR and MR curves more elastic; - Short run profit max. MC = MR; - Can make supernormal profit (short-run): - As does perfectly competitive firm (shaded area); - Depends on demand strength, position & elasticity; - Increases with product differentiation; - Firm’s SR-Profit greater when D curve is less elastic & further to the right of the AC curve John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Short-run Equilibrium of the Firm Under Monopolistic Competition MC $ AR (D) MR AC Ps Economic Profit ACs Q Qs John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Monopolistic Competition New firms enter when supernormal profits are being made; New firms steal customers from established firms; Demand for established firms product falls: - Their D (AR) curve will shift leftwards as long as supernormal profits remain and new firms keep entering; LR equilibrium only normal profits & no incentive for entry (Figure 7.1 (b)) next slide. To right of equilibrium, LRAC is > AR and < normal profits are made. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Long-run Equilibrium of the Firm Under Monopolistic Competition $ LRMC LRAC ARL (DL) MRL PL Q QL John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Long-run Equilibrium of the Firm Under Monopolistic Competition Non-price competition Product development: To produce a high demand product; Different from rival’s product; Better than rivals (personal service, late opening, certain lines stocked, etc.); Inelastic demand due to lack of close substitutes; Advertising: - To sell the product; - Increases demand and makes the demand curve less elastic (stresses product qualities over that of rivals); - Optimal advertising is where MRA = MCA; - As long as MRA > MCA additional advertising will add to profits - Extra amounts spent on advert. Will lead to smaller & smaller increases in sales; - Thus MRA falls until it is = MCA, then no further profit can be gained from adverts. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Monopolistic Competition Product development and advertising effects on D are difficult to forecast. - Different effects at different prices; - Profit Max. involves opt. combination of price, product type, advertising level & variety. The public interest - comparison with perfect competition: - Higher price & lower quantity; - Not producing at least-cost point; - Therefore have excess capacity (could move to Min. LRAC); - Large number of firms (petrol stations) all operating at less than optimum output & hence being forced to charge a higher P than could with bigger turnover; - Difference with Perfect Comp. likely to be small; - Downward sloping D curve likely to be highly elastic due to large number of substitutes; - Greater variety of products to choose from; - each firm may satisfy some particular requirement of particular consumers John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Monopolistic Competition Comparison with monopoly: - V.similar to comparing monopoly with perfect competition; - Prices kept down by freedom of entry and lack of supernormal profits (cost savings); - Less economies of scale than monopoly hence less funds for investment and R&D. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Figure 7.2 Long-run Equilibrium of the Firm Under Perfect and Monopolistic Competition $ LRAC P1 P2 DL under perfect competition DL under monopolistic competition Q Q1 Q2 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly Key features of oligopoly: - Few firms share large portion of the industry; - Virtually identical products e.g. metals, chemicals, sugar, petrol) or, - Differentiated products e.g. cars, soap powder, soft drink, banking services; - Competition is in brand marketing (1) Barriers to entry: – several similar to monopoly (p. 122); – Vary from industry to industry (some cases easy in others virtually impossible). (2) Interdependence of the firms: - Only a few firms each affected by other’s actions - so take account of each other’s decisions; - So mutually dependent – very difficult to make predications without knowing how rivals will react: - no general accepted theory of oligopoly; (3) Examples in Australia: - Motor vehicle industry, banking industry, supermarket retailers John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly The Banking Oligopoly Shares of Total Banking Assets, 2006 (%) Commonwealth Bank 18.6 National Australia Bank 18.2 Westpac 15.2 ANZ 14.6 All other banks 33.3 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly – Two Incompatible Directions: Collusion from firm interdependence: - Cartel acts like a monopoly to jointly maximise profits; Competition to gain bigger share of industry profits for themselves causes aggregate profit loss: - Price competition drives down average industry Price; - Competition through advertising raises industry costs. Equilibrium of the industry: - For cartel: (1) Firms agree on prices, market share, advertising exp, etc. (2) Reduces their uncertainty and fear of competitive price cutting or retaliatory advertising – both could reduce total industry profits; (3) can compete against each other using non-price competition or allocate quotas. If quota sum > Q1 price would have to fall to clear. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Cartel $ Industry D = AR Q John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Cartel $ Industry MC = Horizontal sum of individual firms P1 Industry D = AR Industry MR Q1 Q John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly Tacit collusion Firms keep to a price set by established leader (told price), or Firms constantly follow leader’s changing prices (follow price): Leader may prove reliable to follow - best barometer of market conditions; Barometric firm price leadership (barometric firm may change frequently): Problems: Assumes followers will want to maintain a constant market share; Followers may want to supply more at higher price, or Followers may decide to maintain market share for fear of retaliation from the leader like price cuts or aggressive advertising campaign. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Price Leader Setting Price -Aiming to Maximise Profits for a Given Market Share $ Assume constant market share for leader AR = D market AR = D leader MR leader Q John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Price Leader Aiming to Maximise Profits for a Given Market Share (Barometric method is similar – Although firm not dominating) $ MC l t PL QL a QT AR = D market AR = D leader MR leader Q John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly Tacit collusion – Other forms Average cost pricing: Add a percentage for profit on top of average costs; Used in inflationary times – rule of thump; Price benchmarks: Will round up to $9.95, $14.95, $19.95 but not $12.31, $16.42, $20.04; Both Methods: Applied to advertising – no criticism of other products only praise your own (no everlasting light bulb) John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly Factors favouring collusion Few firms – well know to each other; Open with each other about costs & production methods; Similar production methods and average costs: Therefore will want to change prices at same time by same percent. Similar products & can reach price agreements; There is a dominant firm; Significant entry barriers – little fear of disruption by new firms; The market is stable – sets certainty for agreements; No government measures to curb collusion. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly Breakdown of collusion is concerned with: Price, quantity, advertising & product development; Strategy choice depends on anticipated rival reaction & willingness to gamble. Game theory: Assume 2 firms with identical costs, products and demand; Both considering alternative price to charge – table 7.1 shows profit payoffs; Maximum and Minimum payoffs; Nash equilibrium – equilibrium outcome where there is no collusion between the players; Prisoner’s dilemma – tempted to cheat and cut prices from collusion; Importance of timing of decisions. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profits for Firms A and B at Different Prices Table 7.1 X’s price $2.00 $1.80 A B $5m for Y $12m for X $2.00 $10m each Y’s price C D $12m for Y $5m for X $1.80 $8m each John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

The Prisoners' Dilemma A B C D Sue's alternatives Bill's alternatives Not confess Confess A B Bill gets 10 years Sue gets 3 months Not confess Each gets 1 year Bill's alternatives C D Bill gets 3 months Sue gets 10 years Each gets 3 years Confess John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly Ampol promises to match a competitors price within a radius: - Competitors believe this promise; - Competitors believe that Ampol will not undercut their price; - what price for the only other petrol station in region? - Price that will maximise its profits assuming that Ampol will charge the same price; - In absence of other providers, is likely to charge a relatively high price; - Now assume several petrol stations in locality, so what should the company do know? - Perhaps charge same as Ampol and hope that no other company charges lower forcing Ampol to cut its price? - Assuming that Ampol’s threat is credible, other companies are likely to reason similarly. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly Importance of Timing: - Most decisions are made firms individually rather than similtaneously; - Sometimes an individual firm will take the initiative at other times it will respond to the decision of the other firms; - The following decision try illustrates this: - Assume a market for both a 500 seater and 400 seater version of new type of aircraft; - But not big enough for two airlines – Boeing and Airbus; - Assume: (1) 400 seater => $50m annual profit to single manufacturer; (2) 500 seater => $30m annual profit to single manufacturer; (3) If both manufacturers produced the same version they would each make an annual loss of $10m - There is clearly a first mover advantage in decision tree: (1) Once Boeing decides to build the more profitable version of the plane, Airbus is forced to build the less profitable version; (2) Naturally, Airbus would like to build the more profitable version, and be the first mover; (3) Which airline moves first depends on their advanced R&D and production capacity John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

A Decision Tree Airbus decides Boeing decides Airbus decides (1) B1 Boeing –$10m Airbus –$10m (1) 500 seater Airbus decides B1 500 seater 400 seater Boeing +$30m Airbus +$50m (2) Boeing decides A 400 seater Boeing +$50m Airbus +$30m (3) 500 seater Airbus decides B2 400 seater Boeing –$10m Airbus –$10m (4) John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly More complex decision trees: The ‘game’ becomes more like chess; With many moves and several options on each move; Greater than two companies the decision tree becomes more complex still; More complex ‘games’ can be devised: - With more than two firms, many alternative prices, differentiated products, and various forms of non-price competition (e.g. advertising); - In such cases, the cautious (maximin) strategy may suggest a different policy (e.g. do nothing) from high risk (maximax) strategy (e.g. cut prices substantially); - Firms can alter their tactics in the light of new circumstances; - They may compete for a while, then realise that no one is winning, then jointly raise prices and reduce advertising; - Later, after a period of tacit collusion, competition may break out again; - Caused by entry of new firms; - New product designs; - Change in market demand; - Temptation to cheat. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly – Non-Collusive & the kinked demand curve Oligopolists face a kinked demand curve during price wars and are therefore reluctant to change their prices: One oligopolist cuts its price: Rivals will feel forced to follow suit to prevent losing customers to the first firm; One oligopolist raises its price: Rivals will not follow suit to gain customers from the first firm; Kinked demand curve at current price and output (Figure 7.6): Rise in price: (1) Large sales revenue fall as customers switch to lower priced rivals; (2) Hence a reluctance to raise price; (3) Demand is relatively elastic above the kink; Fall in price (1) Brings only modest sales increase; (2) Because rivals lower their prices to and customers do not switch; (3) Firm is reluctant to reduce its price; (4) Demand is relatively inelastic below the kink John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Kinked Demand for a Firm Under Oligopoly $ Current price and quantity give one point on demand curve P1 Q1 O Q John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Kinked Demand for a Firm Under Oligopoly $ D P1 D O Q Q1 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Stable Price Under Conditions of a Kinked Demand Curve $ MC2 MC1 P1 a b D = AR O Q Q1 MR John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly and the Consumer Oligopolistic firms are also reluctant to change prices because it: Involves modifying price lists; Working out new revenue predications; Revaluing stock of finished goods; May upset customers; Colluding like monopoly to charge high prices – not in consumer interest. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly and the Consumer More of a disadvantage than monopoly for consumer: - May be less scope for economies of scale to mitigate the effects of market power; - Oligopolists are likely to engage in more extensive advertising than monopolist; - These are less severe with no oligopolistic collusion, some price competition and weak barriers to entry; - Oligopolistic power can be offset (in some markets) if they sell their product to other powerful firms (supermarket – countervailing power). John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Oligopoly and the Consumer Oligopolistic advantages over other market structures: - Can use part of supernormal profit for R&D (like monopolies); - have considerable incentive to do so (unlike monopolies); - product improvement results in greater market share and rivals may take some time to respond; - Lowered costs from technological improvement => higher profits => withstand price war; - More consumer choice from product differentiation; (car stereo equipment & non price competition); - Difficult to draw general conclusion, since oligopolies differ so much in performance. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Price Discrimination Meaning of price discrimination: Different prices for different population groups (markets) when production costs do not vary. First degree: Approximate examples in Australia could include bargaining at market stalls, and some services. Second degree: Examples in Australia include water, electricity, bulk buying. Third degree (the most common form): Examples in Australia include cinema tickets, airline tickets, rail and bus tickets (adults, children, pensioners, etc.) John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Price Discrimination Conditions necessary for price discrimination: - Firms must be able to determine own price (not price takers such as in perfect competition); - Separate markets – consumers in one market cannot resell in another market at increased price (children’s tickets resold as adult tickets); - Differing demand elasticities in each markets; (1) A higher price where demand is less elastic and hence less sensitive to price rise. John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Price Discrimination Advantages to the firm: - Earns higher revenue from any given level of sales (Figure 7.7) - Drive competitors out of business - Predatory pricing (1) A monopoly in one market (e.g. home market) may charge a high price due to its relatively inelastic demand and thus make high profits; (2) If it is under oligopoly in another market (e.g. export market) it may use the high profits in the first market to subsidise a very low price in the oligopolistic market, John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Third-degree Price Discrimination Revenue from a single price P1 200 O Q John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Third-degree Price Discrimination (Figure 7.7) Increased revenue from price discrimination P2 150 A higher discriminatory price is now introduced P1 D O Q 200 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Output Under Third-degree Price Discrimination (Box 7.4) DX MRX (a) Market X John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Output Under Third-degree Price Discrimination (Box 7.4) DY DX MRY MRX (a) Market X (b) Market Y John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Output Under Third-degree Price Discrimination (Box 7.4) DY DX MRY MRT MRX (c) Total (markets X + Y) (a) Market X (b) Market Y John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Output Under Third-degree Price Discrimination (box 7.4) MC DY DX MRY MRT MRX (c) Total (markets X + Y) (a) Market X (b) Market Y John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Output Under Third-degree Price Discrimination (Box 7.4) MC DY DX MRY MRT 3000 MRX (c) Total (markets X + Y) (a) Market X (b) Market Y John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Output Under Third-degree Price Discrimination (Box 7.4) MC 5 DY DX MRY MRT 3000 MRX (c) Total (markets X + Y) (a) Market X (b) Market Y John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Output Under Third-degree Price Discrimination (Box 7.4) MC 5 DY DX MRY MRT 1000 3000 MRX (c) Total (markets X + Y) (a) Market X (b) Market Y John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising output under third degree price discrimination (Box 7.4) MC 5 DY DX MRY MRT 1000 2000 3000 MRX (c) Total (markets X + Y) (a) Market X (b) Market Y John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Output Under Third-degree Price Discrimination (box 7.4) MC 9 5 DY DX MRY MRT 1000 2000 3000 MRX (c) Total (markets X + Y) (a) Market X (b) Market Y John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Profit-maximising Output Under Third-degree Price Discrimination (Box 7.4) MC 9 7 5 DY DX MRY MRT 1000 2000 3000 MRX (c) Total (markets X + Y) (a) Market X (b) Market Y John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Price Discrimination and the Consumer Some benefit and others lose; Those paying the higher price will feel unfairly treated; Those charged the lower price may be able to obtain a good or service they could otherwise not afford: - Concessionary bus fares for senior citizens. Allows for increased profits and sometimes less competition John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia