On Level Econ: Imperfect Competition 1 Copyright ACDC Leadership 2015

Imperfect Competition FOUR MARKET STRUCTURES Perfect Competition Monopolistic Competition Monopolistic Competition Pure Monopoly Pure Monopoly Oligopoly Oligopoly Imperfect Competition Every product is sold in a market that can be considered one of the above market structures. For example: Fast Food Market The Market for Cars Market for Operating Systems (Microsoft) Strawberry Market Cereal Market 2 Copyright ACDC Leadership 2015

Monopoly 4 Copyright ACDC Leadership 2015

Four Market Structures Perfect Competition Monopolistic Competition Monopoly Oligopoly Characteristics of Monopoly: Examples: The Electric Company, De Beers(Diamond) One large firm (the firm is the market) Unique product (no close substitutes) High Barriers- Firms cannot enter the industry Monopolies are “Price Makers” Some advertising Copyright ACDC Leadership 2015

What do you already know about monopolies? True or False? All monopolies make a profit. Monopolies are usually efficient. All monopolies are bad for the economy. All monopolies are illegal. Monopolies charge the highest price possible The government never prevents monopolies from forming. All are False 6 Copyright ACDC Leadership 2015

Can a monopoly be good for the economy? Ex: Electric Companies If there were three competing electric companies they would have higher costs. Having only one electric company keeps prices low Economies of scale make it impractical to have smaller firms. Natural Monopoly- It is NATURAL for only one firm to produce because they can produce at the lowest cost. 7 Copyright ACDC Leadership 2015

Regulating Monopolies Copyright ACDC Leadership 2015

Why Regulate? How do they regulate? Why would the government regulate an monopoly? To keep prices low To make monopolies efficient How do they regulate? Use Price controls: Price Ceilings Why don’t taxes work? Taxes limit supply and that’s the problem Copyright ACDC Leadership 2015

Where should the government place the price ceiling? 1.Socially Optimal Price P = MC (Allocative Efficiency) OR 2. Fair-Return Price (Break–Even) P = ATC (Normal Profit) Copyright ACDC Leadership 2015

Perfect Price Discrimination Copyright ACDC Leadership 2015

Price Discrimination Price Discrimination: Practice of selling the same products to different buyers at different prices Examples: Airline Tickets (vacation vs. business) Movie Theaters (child vs. adult) All Coupons (spenders vs. savers) EHHS football games (students vs. parents) Copyright ACDC Leadership 2015

Price Discrimination Requires the following conditions: Price discrimination seeks to charge each consumer what they are willing to pay in an effort to increase profits. Those with inelastic demand are charged more than those with elastic Requires the following conditions: Must have monopoly power Must be able to segregate the market Consumers must NOT be able to resell product Copyright ACDC Leadership 2015

Monopolistic Competition Copyright ACDC Leadership 2015

Characteristics of Monopolistic Competition: Perfect Competition Monopolistic Competition Monopolistic Competition Pure Monopoly Pure Monopoly Oligopoly Oligopoly Characteristics of Monopolistic Competition: Relatively Large Number of Sellers Differentiated Products Some control over price Easy Entry and Exit (Low Barriers) A lot of non-price competition (Advertising) Copyright ACDC Leadership 2015

Examples: Fast Food Restaurants Furniture companies Jewelry stores Hair Salons Clothing Manufacturers Copyright ACDC Leadership 2015

“Monopoly” + ”Competition” Monopolistic Qualities Control over price of own good due to differentiated product Plenty of Advertising Not efficient Perfect Competition Qualities Large number of smaller firms Relatively easy entry and exit Zero Economic Profit in Long-Run since firms can enter Copyright ACDC Leadership 2015

Differentiated Products Goods are NOT identical. Firms seek to capture a piece of the market by making unique goods. Since these products have substitutes, firms use NON-PRICE Competition. Examples of NON-PRICE Competition Brand Names and Packaging Product Attributes Service Location Advertising (Two Goals) 1. Increase Demand 2. Make demand more INELASTIC Copyright ACDC Leadership 2015

Differentiated Products 19 Copyright ACDC Leadership 2015

Why does DEMAND shift? When short-run profits are made… New firms enter. New firms mean more close substitutes and less market shares for each existing firm. Demand for each firm falls. When short-run losses are made… Firms exit. Result is less substitutes and more market shares for remaining firms. Demand for each firm rises. Copyright ACDC Leadership 2015

Review Identify the 4 market structures. Define Price Discrimination. List characteristics of monopolistic competition. List Monopolistic Qualities. List Competitive Qualities. List examples of non-price competition. List two goals of advertising. Copyright ACDC Leadership 2015

Oligopoly Copyright ACDC Leadership 2015

Characteristics of Oligopolies: FOUR MARKET MODELS Perfect Competition Monopolistic Competition Pure Monopoly Oligopoly Characteristics of Oligopolies: A Few Large Producers (Less than 10) Identical or Differentiated Products High Barriers to Entry Control Over Price (Price Maker) Mutual Interdependence Firms use Strategic Pricing Examples: OPEC, Cereal Companies, Car Producers Copyright ACDC Leadership 2015

HOW DO OLIGOPOLIES OCCUR? Oligopolies occur when only a few large firms start to control an industry. High barriers to entry keep others from entering. Types of Barriers to Entry 1. Economies of Scale Ex: The car industry is difficult to enter because only large firms can make cars at the lowest cost 2. High Start-up Costs 3. Ownership of Raw Materials Copyright ACDC Leadership 2015

The study of how people behave in strategic situations Game Theory The study of how people behave in strategic situations An understanding of game theory helps firms in an oligopoly maximize profit. Copyright ACDC Leadership 2015

John Nash and Game Theory Copyright ACDC Leadership 2015

Game theory helps predict human behavior Where is the best location? THE ICE CREAM MAN SIMULATION 1. You are a ice cream salesmen at the beach 2. You have identical prices as another salesmen. 3. Beachgoers will purchase from the closest salesmen 4. People are evenly distributed along the beach. 5. Each morning the two firms pick locations on the beach Where is the best location? Copyright ACDC Leadership 2015

Where should you put your firm? Firm A decides where to goes first. B A Firm A decides where to goes first. What is the best strategy for choosing a location each day? Can you predict the end result each day? How is this observed in the “real-world”? Copyright ACDC Leadership 2015

Where should you put your firm? Firm A decides where to goes first. B Firm A decides where to goes first. What is the best strategy for choosing a location each day? Can you predict the end result each day? How is this observed in the “real-world”? Copyright ACDC Leadership 2015 *Note to teachers* (delete) Assign one student firm A and another student firm B. Ask firm A to put their ice cream anywhere along the beach. (the best place is right in the middle) Ask firm B to put theirs in the most profitable location. (the best place is right next to firm A) Explain that if firm B puts theirs anywhere other than right next to firm A they will be less profitable Repeat with firm B choosing first. Students learn that game theory explain why fast food restaurants and gas stations are often located near each other

SIMULATION! Why learn about game theory? Oligopolies are interdependent since they compete with only a few other firms. Their pricing and output decisions must be strategic as to avoid economic losses. Game theory helps us analyze their strategies. SIMULATION! Copyright ACDC Leadership 2015

Both Deny = 5 Years in jail each Both Confess= 10 Years in jail each The Prisoner’s Dilemma Charged with a crime, each prisoner has one of two choices: Deny or Confess Prisoner 2 Deny Confess   Both Deny = 5 Years in jail each Confess = Free Deny =20 Years Deny Prisoner 1 Confess = Free Deny = 20 Years Both Confess= 10 Years in jail each Confess Copyright ACDC Leadership 2015

Game Theory Matrix Copyright ACDC Leadership 2015

Without talking, write down your choice Game Theory Matrix You and your partner are competing firms. You have one of two choices: Price High or Price Low. Without talking, write down your choice Firm 2 High Low   Both High = $20 Each Low = $30 High = 0 High Firm 1 High = 0 Low = $30 Both Low= $10 each Low Copyright ACDC Leadership 2015

Game Theory Matrix Firm 2 Firm 1 Notice that you have an incentive to collude but also an incentive to cheat on your agreement Firm 2 High Low   Both High = $20 Each Low = $30 High = 0 High Firm 1 High = 0 Low = $30 Both Low= $10 each Low Copyright ACDC Leadership 2015

Dominant Strategy Firm 2 $100, $50 $60, $90 Firm 1 $50, $40 $20, $10 The dominant strategy is the best move to make regardless of what your opponent does What is each firm’s dominate strategy? Firm 2 High Low   High $100, $50 $60, $90 Firm 1 $50, $40 $20, $10 Low Firm #1-Dominant strategy is high since they should always go high Firm #2- Doesn’t have a dominate strategy Copyright ACDC Leadership 2015

Dominant Strategy Firm 2 $100, $50 $60, $90 Firm 1 $50, $40 $20, $10 Nash Equilibrium- The optimal outcome that will occur when both firms make decisions simultaneously and have no incentive to change Firm 2 High Low   High $100, $50 $60, $90 Firm 1 $50, $40 $20, $10 Low The Nash Equilibrium- Firm 1 High, Firm 2 Low Since Firm 1 will always go high, Firm 2 will decided to go low Copyright ACDC Leadership 2015

Video: Split or Steal Copyright ACDC Leadership 2015

Episode 8: The Dark Knight Econmovies Episode 8: The Dark Knight

What did we learn? Oligopolies must use strategic pricing (they have to worry about the other guy) Oligopolies have a tendency to collude to gain profit. (Collusion is the act of cooperating with rivals in order to “rig” a situation) Collusion results in the incentive to cheat. Firms make informed decisions based on their dominant strategies Copyright ACDC Leadership 2015