Unit IV: Imperfect Competition

Characteristics of Monopolies

5 Characteristics of a Monopoly 1. Single Seller One Firm controls the vast majority of a market The Firm IS the Industry 2. Unique good with no close substitutes 3. “Price Maker” The firm can change the price by changing the quantity it produces (ie. shifting the supply curve to the left).

5 Characteristics of a Monopoly 4. High Barriers to Entry New firms CANNOT enter market No immediate competitors 5. Some “Nonprice” Competition Despite having no close competitors, monopolies still advertise their products in an effort to increase demand.

Examples of Monopolies

Four Origins of Monopolies 1. Geographical Monopolies Ex: Nowhere gas stations, De Beers Diamonds, San Diego Chargers, Cable TV, Qualcomm Hot Dogs… -Location or control of resources limits competition and leads to one supplier. 2. Government Monopolies Ex: Water Company, Firefighters, The Army, Pharmaceutical drugs, rubix cubes… -Government allows monopoly for public benefits or to stimulate ingenuity. -The government issues patents to protect inventors and forbids others from using their invention. (They last 20 years)

Four Origins of Monopolies 3. Technological Monopolies Ex: Microsoft, Intel, Frisbee, Band-Aide… -Patents and widespread availability of certain products lead to only one major firm controlling a market. 4. Natural Monopolies Ex: Electric Companies (SDGE) 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. -Low average total costs act as a barrier to entry for other firms.

Assume that 200 units need to be produced Electric companies have economies of scale. The more they produce the lower the average cost. Assume that 200 units need to be produced $20 15 LRATC Average Total Cost 10 If there are 4 firms, the ATC is $20 If there are 2 firms the ATC is $15 If there is 1 firm the ATC is $10 50 100 200 Quantity

Drawing Monopolies

Good news… Only one graph because the firm IS the industry. The cost curves are the same The MR= MC rule still applies Shut down rule still applies Unlike perfect competition, all imperfectly competitive firms have downward sloping demand curve. To sell more a firm must lower its price.

Combine the Demand of an industry with the costs of a firm. MC ATC What about MR? Costs (dollars) D Quantity

Does the Marginal Revenue equal the price? To sell more a firm must lower its price. What happens to Marginal Revenue? Price Quantity Demanded Total Revenue Marginal Revenue $6 $5 1 $4 2 $3 3 $2 4 $1 5 Does the Marginal Revenue equal the price?

Does the Marginal Revenue equal the price? To sell more a firm must lower its price. What happens to Marginal Revenue? Price Quantity Demanded Total Revenue Marginal Revenue $6 $5 1 5 $4 2 8 $3 3 9 $2 4 $1 Does the Marginal Revenue equal the price?

Plot Demand and Marginal Revenue Curves To sell more a firm must lower its price. What happens to Marginal Revenue? Price Quantity Demanded Total Revenue Marginal Revenue $6 - $5 1 5 $4 2 8 3 $3 9 $2 4 -1 $1 -3 MR DOESN’T EQUAL PRICE Plot Demand and Marginal Revenue Curves

Plot Demand and Marginal Revenue Curves Quantity Price TR MR $16 - 1 15 2 14 28 13 3 39 11 4 12 48 9 5 55 7 6 10 60 63 8 64 -1 -3

Plot Demand and Marginal Revenue Curves Quantity Price TR MR $16 - 1 15 2 14 28 13 3 39 11 4 12 48 9 5 55 7 6 10 60 63 8 64 -1 -3

Why is MR below Demand? P As price decreases from $100 to $90... revenue will increase with the additional unit sold. $100 90 60 40 TR=$300 D TR = $360 Q 1 2 3 4 5 6

Why is MR below Demand? P D Q $100 90 60 40 But a lower price results in a loss of the $30 that was earned when price was $10 higher $100 90 60 40 Loss = $30 TR=$300 D TR = $360 Gain = $90 Q 1 2 3 4 5 6

Why is MR below Demand? P D Q $100 90 60 40 Marginal Revenue is ADDITIONAL REVENUE MR= (Price –Loss from lowering price) MR= $90 - $30 = $60 $100 90 60 40 Loss = $30 TR=$300 D TR = $360 Gain = $90 Q 1 2 3 4 5 6

Why is MR below Demand? MR= $80 – 40 = $40 P As price decreases from $90 to $80 TR increases MR= $80 – 40 = $40 $100 90 80 60 40 Loss= $40 D Gain = $80 Q 1 2 3 4 5 6

Why is MR below Demand? P $100 90 80 60 40 D MR Q 1 2 3 4 5 6

Why is MR below Demand? MR CURVE IS LESS THAN DEMAND CURVE!!! P D Q $100 90 80 60 40 MR CURVE IS LESS THAN DEMAND CURVE!!! D MR Q 1 2 3 4 5 6

Elastic vs. Inelastic Range of Demand Curve

Elastic and Inelastic Range $200 150 100 50 Dollars Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 $750 500 250 Dollars Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Elastic and Inelastic Range $200 150 100 50 Total Revenue Test If price falls and TR increases then demand is elastic. Dollars MR D Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 $750 500 250 Dollars TR Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Elastic and Inelastic Range $200 150 100 50 Total Revenue Test If price falls and TR increases then demand is elastic. Dollars MR D Q Total Revenue Test If price falls and TR falls then demand is inelastic. 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 $750 500 250 Dollars When MR goes negative, TR will fall TR Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Putting Demand, MR, and Cost Together

MR = MC What output should this monopoly produce? How much is the TR, TC and Profit or Loss? Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue $9 8 7 6 5 4 3 2 MC ATC Profit =$5 D MR

Price, costs, and revenue Conclusion: A monopolists produces where MR=MC, buts charges the price consumer are willing to pay identified by the demand curve. Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue $9 8 7 6 5 4 3 2 MC ATC D MR

How much is the TR, TC, and Profit or Loss? What if cost are higher? How much is the TR, TC, and Profit or Loss? Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue MC ATC 140 Loss AVC D Minimum AVC is shut down point MR Q

Identify and Calculate: TR= TC= Profit/Loss= Profit/Loss per Unit= $780 Identify and Calculate: $600 $180 Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue $30 MC $130 ATC $110 D MR

Are Monopolies Efficient?

Because there is little external pressure to be efficient Monopolies are inefficient because they… Charge a higher price Under produce Not allocativly efficiency Produce at higher costs No productive efficiency Have little incentive to innovate Why? Because there is little external pressure to be efficient

INEFFICIENCY OF PURE MONOPOLY An industry in pure competition S = MC CS Pc PS D Q Qc

INEFFICIENCY OF PURE MONOPOLY S = MC At MR=MC A monopolist will sell less units at a higher price than in competition Pm Pc D MR Q Qm Qc

Result is DEADWEIGHT LOSS to society CS and PS of a Monopoly P Result is DEADWEIGHT LOSS to society S = MC CS Pm Pc PS D MR Q Qm Qc

CS and PS of a Monopoly P Result is DEADWEIGHT LOSS to society S = MC CS Pm Pc PS Monopoly pricing causes consumers to overpay so CS becomes PS D MR Q Qm Qc

Are Monopolies Productively Efficient? No. They are not producing at the lowest cost (min ATC) Does Price = Min ATC? Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue MC ATC D MR

Does Price = MC? Do Monopolies Have Allocative Efficiency? No. Price is greater. The monopoly is under producing. Does Price = MC? Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue MC ATC D MR

Regulating Monopolies

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-that’s the problem

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)

REGULATED NATURAL MONOPOLY Monopoly Price MR = MC P Pm Price and Costs ATC MC D MR Q Qm

REGULATED NATURAL MONOPOLY Fair-Return Price Normal Profit Only TR = TC Price and Costs ATC Pf MC D MR Q Qf

REGULATED NATURAL MONOPOLY Socially-Optimum Price P = MC Price and Costs ATC MC Pr D MR Q Qr

REGULATED NATURAL MONOPOLY Dilemma of Regulation Which Price? P MR = MC Fair-Return Price Pm Socially-Optimum Price Price and Costs ATC Pf MC Pr D MR Q Qm Qf Qr

Price Discrimination

PRICE DISCRIMINATION Definition: Practice of selling the same products to different buyers at different prices Requires the following conditions: Firm must have monopoly power Firm must be able to segregate the market Consumers must not be able to resell product

PRICE DISCRIMINATION Examples: 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 Examples: Airline Tickets (vacation vs. business) Movie Theaters (child vs. adult) All Coupons (spenders vs. savers) SPHS soda machine (students vs. teachers)

PRICE DISCRIMINATION Economic profits with a single MR=MC price MC P ATC Price and Costs D MR Q Q1

A perfectly discriminating can charge each person differently so the Marginal Revenue = Demand MC P ATC Price and Costs MR=D D Q Q1 Q2

What output do they make? Where is Consumer Surplus? MC P ATC Price and Costs MR=D D Q Q2

Where is the Profit? Profit with price discrimination MC P ATC Price and Costs MR=D D Q Q1 Q2

What’s the Point? Perfectly price discriminating firms: Make more profit Produce more Produce at allocative efficiency

Allocative Efficiency MC P Price = MC ATC Price and Costs MR=D D Q Q1 Q2

Can You Do The Following? 1.Draw a monopoly making a profit at long-run equilibrium and identify price, quantity, and profit. 2. Draw a perfectly competitive industry AND firm at long-run equilibrium 3. Draw a price discriminating monopoly at equilibrium and label price, quantity, MR, and profit

Monopolistic Competition

FOUR MARKET MODELS Monopolistic Competition: Relatively Large Number of Sellers Differentiated Products Some control over price Easy Entry and Exit Extensive non-price competition Market Structure Continuum Pure Competition Monopoly Monopolistic Oligopoly

Examples: Fast Food Restaurants Furniture companies Jewelry stores Hair Salons Clothing Manufacturers

“Monopolistic” +”Competition” Monopolistic Qualities Control over price of own good due to differentiated product. D > MR Plenty of non-price competition 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.

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 Brand Names and Packaging Product Attributes Service Location Advertising (Two Goals) 1. Increase Demand 2. Make demand more INELASTIC

Drawing Monopolistic Competition

MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC What Happens? ATC $4 $2 Price and Costs Short-Run Economic Profits D MR Q1 Quantity

MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC New Firms Enter ATC In the long-run, new firms will enter, driving down the DEMAND for firms already in the market. $4 $2 Price and Costs Short-Run Economic Profits D MR Q1 Quantity

MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC What will happen? ATC $4 $2 Price and Costs Short-Run Economic Profits D MR Q1 Quantity

LONG- RUN EQUILIBRIUM MC ATC Normal Profit D MR Price and Costs $4 $2 $1 D MR Q1 Quantity

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

With economic losses, firms will exit the market – stability occurs PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC What happens? ATC $7 Price and Costs $1 Short-Run Economic Loss With economic losses, firms will exit the market – stability occurs when economic profits are zero. D MR Q1 Quantity

MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC What happens? ATC $7 Price and Costs $1 Short-Run Economic Loss D MR Q1 Quantity

MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC Long-Run Equilibrium Normal Profit Only ATC $7 Price and Costs D MR Q3 Quantity

MONOPOLISTIC COMPETITION AND EFFICIENCY

MONOPOLISTIC COMPETITION AND EFFICIENCY Not Productively Efficient  Minimum ATC Not Allocatively Efficient Price  MC Firm has Excess Capacity Graphically…

MONOPOLISTIC COMPETITION AND EFFICIENCY MC Long-Run Equilibrium Price is Not = Minimum ATC ATC P3 = A3 Price  MC Price and Costs D MR Q3 Quantity

MONOPOLISTIC COMPETITION AND EFFICIENCY Excess Capacity The gap between the minimum ATC output and the profit maximizing output Given current resources, the firm can produce at minimum ATC, but they decide not to.

MONOPOLISTIC COMPETITION AND EFFICIENCY MC Long-Run Equilibrium ATC P3 = A3 Excess Capacity Price and Costs D MR Q3 Quantity

MONOPOLISTIC COMPETITION Advantages of MONOPOLISTIC COMPETITION Large number of firms and product variation meets societies needs Nonprice Competition (product differentiation and advertising) may result in sustained profits for some firms. Ex: Nike might continue to make above normal profit because they are a well known brand.

Oligopoly

FOUR MARKET MODELS Oligopoly: A Few Large Producers Identical or Differentiated Products Control Over Price, But Mutual Interdependence Firms use Strategic Pricing High Entry Barriers Examples: OPEC, Cereal Companies, Car Producers Market Structure Continuum Pure Competition Monopoly Monopolistic Oligopoly

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 Economies of Scale High Start-up Costs Ownership of Raw Materials

Game Theory

The study of how people behave in strategic situations What is game theory? The study of how people behave in strategic situations A thorough understanding of game theory helps firms in an oligopoly maximize profit.

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!!!!!

Both Deny = 3 Years in jail each Both Confess= 5 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 = 3 Years in jail each Confess =1 Year Deny =7 Years Deny Prisoner 1 Confess = 1 Year Deny = 7 Years Both Confess= 5 Years in jail each Confess

Each firm has one of two choices: Price High or Price Low. Strategic Pricing Each firm has one of two choices: Price High or Price Low. Firm 2 High Low   Both High = 2 Each Low = 3 High = 0 High Firm 1 Low = 3 High = 0 Both Low= 1 each Low

A B C D A Game-Theory Overview OLIGOPOLY BEHAVIOR $12 $15 $6 $8 RareAir’s Price Strategy High Low B A D C $12 $15 $6 $8 High Low Uptown’s Price Strategy

Greatest Combined Profit if both Sell High OLIGOPOLY BEHAVIOR Greatest Combined Profit if both Sell High RareAir’s Price Strategy High Low B A D C $12 $15 $6 $8 High Low Uptown’s Price Strategy

Each firm recognizes that more profit is made if they lower price OLIGOPOLY BEHAVIOR Each firm recognizes that more profit is made if they lower price RareAir’s Price Strategy High Low B A D C $12 $15 $6 $8 High Low Uptown’s Price Strategy

BUT if both lower price they end up in the Worst Case OLIGOPOLY BEHAVIOR BUT if both lower price they end up in the Worst Case RareAir’s Price Strategy High Low B A D C $12 $15 $6 $8 High Low Uptown’s Price Strategy

To make more profit, firms may try to cooperate (collude) OLIGOPOLY BEHAVIOR To make more profit, firms may try to cooperate (collude) RareAir’s Price Strategy High Low B A D C $12 $15 $6 $8 High Low Uptown’s Price Strategy

To make more profit, firms may try to cooperate (collude) OLIGOPOLY BEHAVIOR To make more profit, firms may try to cooperate (collude) RareAir’s Price Strategy High Low B A D C $12 $15 $6 $8 High Low Uptown’s Price Strategy

But now each firm has the incentive to cheat. OLIGOPOLY BEHAVIOR But now each firm has the incentive to cheat. RareAir’s Price Strategy High Low B A D C $12 $15 $6 $8 High Low Uptown’s Price Strategy

What did we learn? Oligopoly pricing must be strategic 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.

Oligopoly Graphically

THREE OLIGOPOLY MODELS Not one standard model due to... Complications of Interdependence Instead there are 3 Alternative Models: 1 – Price Leadership (no graph) 2 – Cartels and Collusion (known graph) 3 – Kinked Demand Curve (new graph)

Price Leadership

PRICE LEADERSHIP MODEL Collusion is ILLEGAL. Firms CANNOT set prices. Price leadership is a strategy used by firms to coordinate prices without outright collusion General Process: “Dominant firm” initiates a price change Other firms follow the leader Example: 3 competing gas stations.

PRICE LEADERSHIP MODEL Breakdowns in Price Leadership Temporary Price Wars may occur if other firms don’t follow price increases of dominant firm. Each firm tries to undercut each other. Example: Employee Pricing for Ford

Cartels and Collusion

Cartel = Colluding Oligopoly CARTELS AND COLLUSION Cartel = Colluding Oligopoly A cartel is a group of producers that create a formal agreement to fix prices high. Examples: 1. Overt Collusion- OPEC ( Organization of Petroleum Exporting Countries) 11 countries set limits on the supply of oil 2. Covert Collusion- In 1998, Toys R’ Us and Toy manufacturers were sued by the government for having secret price fixing meetings.

Characteristics of Cartels Cartels set price and output at an agreed upon price Firms require identical or highly similar demand and costs Cartel must have a way to punish cheaters Together they act as a monopoly Graphically…

Colluding Oligopolists Will Split the Monopoly Profits. CARTELS AND OTHER COLLUSION Colluding Oligopolists Will Split the Monopoly Profits. D MC ATC MR Economic Profit MR = MC Price and costs Q0 P0 A0

Kinked Demand Curve

Kinked Demand Curve Model The kinked demand curve model is a graphic portrayal of the interdependency of noncollusive firms. Noncollusive firms are likely to react to competitor’s pricing in two ways: 1. Match price-If one firm cuts it’s prices, then the other firms follow suit causing inelastic demand 2. Ignore change-If one firm raises prices, others maintain same price causing elastic demand

KINKED DEMAND THEORY: The demand and MR curves if other firms match lower pricing If this firm lowers its price and others follow, Qd will increase mildly Price D1 Quantity MR1

KINKED DEMAND THEORY: The demand and MR curves if other firms ignore higher pricing If this firm increases its price and others ignore it, Qd for this firm will decrease significantly Price D2 MR2 Quantity

Two sets of curves based on the pricing decisions of other firms The firm’s demand and marginal revenue curves Price D2 MR2 D1 Quantity MR1

Two sets of curves based on the pricing decisions of other firms Rivals tend to follow a price cut Price D2 MR2 D1 Quantity MR1

Two sets of curves based on the pricing decisions of other firms Rivals tend to follow a price cut or ignore a price increase Price D2 MR2 D1 Quantity MR1

Two sets of curves based on the pricing decisions of other firms Effectively creating a kinked demand curve Price D2 MR2 D1 Quantity MR1

Two sets of curves based on the pricing decisions of other firms Effectively creating a kinked demand curve Price D Quantity

Two sets of curves based on the pricing decisions of other firms What about MR? Price D2 MR2 D1 Quantity MR1

Two sets of curves based on the pricing decisions of other firms Since we use sections of both MR curves, the MR has a vertical gap. MR2 Price D Quantity MR1

NONCOLLUSIVE OLIGOPOLY KINKED DEMAND THEORY: NONCOLLUSIVE OLIGOPOLY Profit maximization MR = MC occurs at the kink. MR2 Price D Quantity MR1

NONCOLLUSIVE OLIGOPOLY KINKED DEMAND THEORY: NONCOLLUSIVE OLIGOPOLY Notice that changes in costs don’t easily change profit maximizing output. MC2 MC1 MR2 Price D Quantity MR1

KINKED DEMAND THEORY: NONCOLLUSIVE OLIGOPOLY The result is stable (or sticky) prices for noncolluding firms. MC2 MC1 MR2 Price D Quantity MR1