Market Equilibrium and Market Demand: Imperfect Competition Chapter 9

Market Structure Characteristics We characterize an industry by The number of firms and their size distribution Product differentiation Barriers to entry The picture to the right concerned with two markets: No. 2 yellow corn: many producers/sellers (Perfect Competition) Farm equipment: few manufacturers/sellers (Oligopoly) 2 Pages 145-148

Perfect Competition Up to now we have been assuming the firm and market reflect conditions of perfect competition Not a bad assumption for many agricultural subsectors A large number of small firms: 2 million farms A homogeneous product: No. 2 yellow corn Freely mobile resources: No barriers to entry caused by patents, etc. or barriers to exit (???) Perfect knowledge of market conditions: Quality outlook information from government, university and private sources 3

Imperfect Competition Many markets in which farmers buy inputs and sell their products however do not reflect perfect competition conditions Chapter 9 focuses on specific types of imperfect competitors in the farm input market These firms are capable of setting prices farmers must pay for specific inputs 4

Imperfect Competition in Selling 5

Topics for Nov 3rd Monopolistic Competition Definition Production and Pricing Decisions Oligopolies Definition/Examples Monopolies Comparison of Market Structures Pages 106-107 6

Imperfect Competition in Selling Unlike perfect competitors who face a perfectly elastic (horizontal) demand curve Imperfect competitors selling a differentiated product have a downward sloping demand curve $ $ Firm’s demand curve under P.C. Firm’s demand curve under imperfect competition A A B B Q 7 Q

Page 149 Table 9-1 Imperfect Competition Price Quantity Total Rev. Avg. Revenue Marginal Revenue 15 -------- ----- 14 2 28 13 4 52 12 6 72 10 11 8 88 100 9 108 112 7 16 18 -2 5 20 -4 22 -6 3 24 -8 26 -10 1 -12 30 -14 Firm faces a downward sloping demand curve → MR ≤ AR 2 20 Marginal Revenue (MR) : Change in revenue from the sale of the last unit of output (ΔTR÷ΔQ) Average Revenue (AR): Total Revenue/Total output (TR÷Q) Note: Price = Average Revenue 8 Page 149

Imperfect Competition in Selling Marginal Revenue: Change in revenue from the sale of the last unit of output 9 Page 150

Imperfect Competition in Selling Maximum Total Revenue Marginal revenue in this instance is also downward sloping MR=0 at the point where TR is at a maximum Page 150 10

Types of Imperfect Competitors in Input Markets Monopolistic Competition Oligopoly Monopoly Let’s start here… 11

Monopolistic Competitors Many sellers Each firm has relatively small market share Power to set prices somewhat like a monopoly Face competition like perfect competition Collusion is not possible given number of firms in the industry No barriers to entry or exit 12 Page 148-151

Monopolistic Competitors Product Differentiation: Each firm makes a product that is slightly different from the products of competing firms Close substitutes but no perfect substitutes An attempt to ↑ price will normally results in a ↓ in volume sold Competition on Quality, Price, Marketing Quality is design, reliability, service provided to buyer and ease of access to product The firm faces a downward sloping demand curve Firm must market intensively: promotions, distribution, packaging, etc. 13 Page 148-151

Monopolistic Competitors Product differentiation does not necessarily mean there are any physical differences among products They might all be the same, but how they are sold may make all the difference 14 Page 148-151

Monopolistic Competitors The monopolistic competitor tries to set his/her product apart from the competition Main method is via advertising When this is done successfully, the demand curve becomes more vertical or inelastic Buyers are willing to pay more because they believe it is much better than their other choices Basis for product differentiation Physical differences Convenience Ambience Reputations Appeals to vanity Snob appea 15 Page 148-151

Monopolistic Competitors Typical Monopolistic Competitor Tries to set firm apart from competition New Product Development and Innovation Advertising Create consumer perception of product differentiation – real or imagined Attempt to keep demand as inelastic as possible Selling costs can be extremely high 16 Page 148-151

Monopolistic Competitors Short run profits can exist but long run profits are reduced to 0 with industry entrants Fast food industry is a good example All services basically the same Extensive use of marketing to differentiate products/services across firms Striving to produce more products and services 17 Page 148-151

Monopolistic Competitors Production Decision: Determine output level where MC=MR (Why does this make sense?) Pricing Decision: Determine where above quantity intersects the downward sloping demand curve 18 Page 148-151

Monopolistic Competition Short run profits exist if: PSR > ATCSR at QSR Short run profits The firm produces QSR where MR=MC at E Prices its products at PSR by reading off the demand curve at quantity QSR Represents consumer’s willingness to pay for QSR Page 150 19

Monopolistic Competition Short run loss At QSR, PSR < ATCSR Page 150 20

Monopolistic Competition In the Long Run (LR) PLR = ATCLR Profits are bid away as more firms enter the market Losses will no longer exist as firms leave the market At QLR the remaining firms are just breaking even PLR = ATCLR Monopolistic Competition 21 Page 151

Monopolistic Competitors How much is the industry dominated or not dominated by few suppliers Geographical scope – national, regional, global An industry can be almost perfectly competitive on a national scope, but almost a monopoly locally e.g. Feed Retailing Barriers to entry and exit: industries may appear concentrated but few barriers exist to prevent entry 22 Page 148-151

Monopolistic Competitors Quantitative measures of competition Concentration Ratio (CR): 2,4, 8, 20, etc % of the value of total market revenue accounted for by 2, 4, 8, 20, etc. largest firms in the industry Low CR values→ a high degree of competition High CR values → an absence of competition 23 Page 148-151

Monopolistic Competitors Quantitative measures of competition Herfindahl-Hirschman Index (HHI): The square of the % market share of each firm summed over the largest 50 firms in an industry or all firms if < 50 in industry Perfect competition, HHI is small Only 1 firm, HHI is 10,000 = (1002) U.S. Justice Department HHI < 1,000 competitive markets HHI > 1,800 could be considered concentrated industry worthy of Justice Dept. examination of any purchases 24 Page 148-151

Oligopolies A few number of sellers Each can impact market price & quantities Interdependent in their decision making Key component in marketing strategies and pricing behavior Match price cuts but not price increases by fellow oligopolists Do this to maintain market share Non-price competition between oligopolists to uniquely identify products 25 Pages 152-155

Oligopolies Rival oligopolists will match price cuts but not price increases in the short run because they want to capture a larger market share If there are differences in prices they are the result of successful product differentiation Tend to have stable prices Changes in production and other costs not easily passed on and may have to be absorbed 26 Pages 152-155

Oligopolies Price leadership strategy A particular firm dominates the market Controls the largest share of the market Other industry firms more efficient in operation, marketing, etc. The dominant firm first sets its price to maximize profit Remaining firms set their prices based on the dominant firms pricing The price set by the oligopolist seller is higher under perfect competition Quantity produced is lower then perfect comp. 27 Pages 152-155

Oligopolies The dominant firm may be efficient enough to set a lower price Eventually drive the other firms out of the market 28 Pages 152-155

Oligopolies Examples of Oligopolies Auto manufacturers 1997 CR4 value of 97.4 Aircraft manufacturing Farm machinery and equipment John Deere, J.I.Case and New Holland 80% of 2-wheel drive tractors close to 90% of combines sold in the U.S. Cattle slaughtering CR4 value increased from 39% to 67% over the 1985-1995 period 29 Pages 152-155

Demand curve DD All oligopolists move prices together and share market Demand curve dd A single firm changes its price Curve DD is more inelastic Below point 1, firms match price cut This leads to a kinked demand curve d1D Leads to a discontinuous marginal revenue curve, d256 6 Remember oligopolists account for the reaction of other firms so there is no single demand curve 30 Page 154

Meeting demand along the lower segment of the kinked demand curve → the firm is maintaining its market share Page 154 31

It does impact profits as MC drops from pt 3 to pt 4 Shifting MC curves reflecting technological advances will not affect PE and QE It does impact profits as MC drops from pt 3 to pt 4 Page 154 32

Monopolies One seller in the market Entry of other firms restricted by patents, etc. (i.e., barrier to entry) Firm has absolute power over setting market price Produces a unique product It can have economic profits in the long run because it can set price without competition 33 Page 155-156

Monopolies Page 155-156 Total revenue = area 0PECQE $/unit Total revenue = area 0PECQE Monopolist produces quantity where MC=MR (pt A), QE Uses the demand curve (pt C) when setting price PE ATC MC AVC C PE B M A N Demand= AR TVC MR Quantity QE 34 Page 155-156

Monopolies $/unit ATC MC AVC Total variable costs for the monopolist is equal to area 0NAQE, (green box) =AVC x QE = 0N x QE C PE B M A N Demand= AR TVC MR Quantity QE 35 Page 155-156

Monopolies Total fixed costs equals NMBA (orange box) =(ATC-AVC) x QE $/unit ATC MC AVC C PE Total fixed costs equals NMBA (orange box) =(ATC-AVC) x QE B M TFC A N Demand= AR MR Quantity QE 36 Page 155-156

Monopolies Total cost is area 0MBQE (green box + orange box) $/unit ATC MC AVC C Total cost is area 0MBQE (green box + orange box) = area ONAQE + area NMBA PE B M TFC N A Demand= AR TVC MR Quantity QE 37 Page 155-156

Monopolies Page 155-156 ATC MC AVC $/unit Economic Profit ATC MC AVC C PE Monopoly economic profit = area MPECB = Total Revenue (yellow box) – Total Costs (green box + orange box) B M TFC A N Demand= AR TVC MR Quantity QE 38 Page 155-156

Monopolies Total fixed costs equals NMBA (orange box) =(ATC-AVC) x QE $/unit ATC MC AVC C PE Economic Profit Total fixed costs equals NMBA (orange box) =(ATC-AVC) x QE B M TFC A N Demand= AR TVC MR Quantity QE 39 Page 155-156

Comparison of Structure Results Lets compare the results we have obtained from the alternative market structures 40

Consumer surplus = sum of areas 1, 4, 5, 8 and 9 (blue triangle) Perfect Competition Case Consumer surplus = sum of areas 1, 4, 5, 8 and 9 (blue triangle) 41 Page 157

Producer surplus = to the sum of areas 2, 3, 6 and 7 (green triangle) Perfect Competition Case Producer surplus = to the sum of areas 2, 3, 6 and 7 (green triangle) Page 157 42

Total economic surplus = sum of blue and green triangles Perfect Competition Case Total economic surplus = sum of blue and green triangles =sum of areas 1 – 9 Page 157 43

CS = sum of areas 8 and 9, (new blue triangle) Compared to P.C., consumers would be economically worse-off by areas 1, 4 and 5 Paying a higher price, PM Purchasing a smaller quantity, QM Monopoly Case Page 157 44

PS = to sum of areas 3, 4, 5, 6 and 7 (green area) Compared to P.C. producers lose area 2 but gain areas 4 + 5 Economically better-off than P.C. Monopoly Case Page 157 45

Society as a whole would be economically worse-off by areas 1+2 Known as the dead weight loss Reflects the fact that less of available resources in this market are used to provide products to consumers Monopoly Case 46 Page 157

Summary of Imperfect Competitors from a Selling Perspective Page 157 47

Imperfect Competition From the Buying Perspective 48

Types of Imperfect Competitors on the Buying Side Monopsonistic competition Oligopsony Monopsony Let’s start here… 49

Monopsonies Single buyer in the input market Focus is on the marginal input cost of purchasing an addition unit of resources Will purchase input until Marginal Value Product (MVP)=Marginal Input Cost (MIC) As long as MVP>MIC, the monopsonist makes a profit 50 Page 158-160

Monopsonies Under perfect competition, the firm views the input supply curve as a horizontal line Firm can purchase as much as desired as the going price Firm’s purchase does not impact inputs cost Monopsonist is the only input buyer →Faces an upward sloping input supply curve Buying decisions impact input prices 51 Page 158-160

Monopsonies Monopsonist must consider the marginal input cost (MIC) when purchasing inputs MIC defined as the change in the cost of an input as more of the input is used Lets look at a simple example Monopsonist must pay higher prices per unit if he/she wants to purchase greater amounts of the input →MIC curve is above the input supply curve 52 Page 158-160

Units of Variable Input Marginal Input Cost Units of Variable Input Price/Unit ($) Total Input Cost Marginal Input Cost 1 3.00 ----- 2 3.50 7.00 4.00 3 12.00 5.00 4 4.50 18.00 6.00 5 25.00 6 5.50 33.00 8.00 7 42.00 9.00 8 6.50 52.00 10.00 9 63.00 11.00 10 7.5 75.00 53 Page 158-160

Marginal Input Cost Marginal Input Cost Input Supply Curve 12 11 10 9 8 Input Supply Curve 7 $/Unit 6 5 4 Data obtained from previous table 3 2 1 1 2 3 4 5 6 7 8 9 10 Quantity/unit of time 54 Page 158-160

Monopsonies Profit maximizing monopsonist Use variable input to the point where Marginal Input Cost (MIC) =Marginal Revenue Product (MRP) MRP = addition to total revenue attributed to the addition of one unit of variable input = Marginal revenue x MPP So long as MRP>MIC, profits will increase with increased input use If MRP<MIC, profits will ↑ by reducing the amount of input used (Why?) 55 Page 158-160

Buying Decisions by Perfect Competitors MRP = MVP under perfect competition MVP=PPC x MPP Page 160 56

Buying Decisions by a Monopsonist Monopsonist makes decisions along MRP curve Differs from MVP MRP=MIC at A Purchase QM inputs Buying Decisions by a Monopsonist 57 Page 160

Buying Decisions by a Monopsonist Resource use Higher Price paid under P.C., PPC Utilization higher under P.C., QPC Price difference referred to as monopsonistic exploitation (i.e., PPC – PM) Buying Decisions by a Monopsonist 58 Page 160

Imperfect Competition on Both Sides Product Selling Perspective Input Purchasing Perspective Perfect Competition Monopolistic Competition Monopsonistic Competition Oligopoly Oligopsony Monopoly Monopsony Can have any combination of the above for a particular firm Lets look at profit maximization under specific cases 59 Page 160

Case #1: Monopsonist in input purchasing and Monopolist seller of product Equilibrium: MRP=MIC at Point A. Pricing off input supply curve gives QMM and PMM 60 Page 161

Case #2: Perfect Competition in input purchasing and Monopoly seller Equilibrium is where MRP=Supply at C No Marginal InputCost curve → QPCM and PPCM 61 Page 161

Case #3: Monopsony in input purchasing and Perfectly Competitive seller Equilibrium: MVP=MIC at Point E Pricing off supply curve → QMPC and PMPC 62 Page 161

Case #4: Perfect Competition in both input purchasing and product sales Equilibrium: MVP=Supply at Point F → QPC and PPC 63 Page 161

Monopsonistic Competitors Many firms buying resources Ability to differentiate services to producers Differentiated services includes distribution convenience and location of facilities, willingness to provide credit or technical assistance P and Q determined same as monopsonist 64 Page 161

Oligopsonies A few number of buyers of a resource Profit earned will depend on elasticity of supply for resource (less elastic than monopsonistic competition) Each oligopsonist knows fellow oligopsonists will respond to changes in price or quantity it might initiate P and Q determined same as monopsonist 65 Page 161

Various segments of the livestock industry Exhibit several forms of imperfect competition. 66 Page 162

Governmental Regulation Various approaches have been used to counteract adverse effects of imperfect competition in the marketplace Legislative acts passed by Congress, including the Sherman Antitrust and Clayton Acts Price ceilings Lump-sum Tax Minimum price or floors 67 Page 162

Legislative Acts Sherman Antitrust Act of 1890 Prohibited monopoly and other restrictive business practices Packers and Stockyards Act of 1921 Reinforced Anit-trust laws regarding livestock marketing Capper-Volstead Act of 1922 Exempted cooperatives from anti-trust laws Robinson-Patman Act Prohibited price discrimination practices Agricultural Marketing Agreement Act Established agricultural marketing orders 68 Page 163

Impacts of Price Ceilings Regulatory agencies such as the Federal Trade Commission can impact monopoly effects by instituting a maximum (ceiling) price FTC charged with investigating business organizations and practices and carrying out anti-trust provisions How can we model the impact of price ceilings? 69 Page 163

Impacts of Price Ceilings Implications of a Price Ceiling Without regulatory involvement the monopolist will Equate MR and MC (point C) Produce QM and charge price PM Earn a profit of A′PMBD D A′ 70 Page 164

Impacts of Price Ceilings Implications of a Price Ceiling With gov’t imposed price ceiling, PMAX The demand curve is given by PMAXED MR is PMAXEFG Mono. produces more (Q1>QM) at a lower price (PMAX < PM) A′ D 71 Page 164

Impacts of Price Ceilings Implications of a Price Ceiling Monopolist’s profit falls to area IPMAXEH (turquoise box) A′ 72 Page 164

Impacts of a Lump Sum Tax A regulatory agencies can impact the level of monopoly profits by assessing a lump-sum tax May be a license fee or one-time charge Corresponds to a fixed tax regardless of output level How can we model the impact of a lump sum tax? 73 Page 165

Impacts of A Lump Sum Tax Implications of Lump-Sum Tax The monopolist equates MC=MR (pt. F) Produces QM Charges PM Profit of APMBC Page 165 74

Impacts of A Lump Sum Tax Implications of Lump-Sum Tax ↑ firm’s ATC from ATC1 to ATC2 ↓ producer surplus from APMBC to EPMBT Does not change output level or price The loss in producer surplus is area AETC (blue box) Page 165 75

Impacts of a Minimum Price In a monopsony, the gov’t could regulate the price of a resource by imposing a minimum price that must be paid for that resource Good example is the various minimum wage laws How can we model the impact of a minimum price policy? 76 Page 165

Impacts of a Minimum Price Implications of a Minimum Price No minimum price Monopsonist determines where MRP=MIC Employ QM input units Pays $PM/unit Implications of a Minimum Price 77 Page 166

Impacts of a Minimum Price Implications of a Minimum Price Minimum price, PF, imposed Monopsonist’s MIC curve would be PFDCB The firm would use more input Implications of a Minimum Price 78 Page 166

Summary Unlike perfect competition, imperfect competitors have ability to influence price Monopolistic competitors try to differentiate their product Monopolists are the only seller in their product market. Monopsonists are the only buyer Oligopolies are a few number of sellers while oligopsonies are a few number of buyers. What are the economic welfare implications of imperfect competition? 79

Chapter 10 focuses on resource use in agriculture and the environment 80