Revision: competition, monopoly, oligopoly Unit 03

A market is in perfect competition if every buyer and every seller is so small that he or she cannot influence prices… … and if goods are perfectly substitutes. If the price is given and invariable… 1.The total revenue increases as quantities increase 2.The average revenue remains invariable 3.The marginal revenue is invariable and equal to price. Goal of the firm: maximising profits

The profit is maximum when marginal revenue = marginal cost

Profits and losses: how to measure them Profit = total revenue – total cost (RT –CT ) or: average revenue – average cost times the quantity ( (RMe – CMeT)  Q ) P = Rme ( (P – CMeT)  Q ) Conversely: Loss = average cost – price times the quantity ( (CMeT – P)  Q ) The quantity Q, respectively, maximises profit or minimises loss.

In the long run: - entry: when price is higher than average total cost ( P > CMeT ) - exit: when price is lower than average total cost ( P < CMeT ) The firm decides to enter the market only if revenues cover all costs, including fixed ones

- equilibrium: when price = average total cost ( P = CMeT ) In the long run profits are equal to zero P

Fundamental cause of monopoly: entry barriers Entry barriers have three causes: 1.A key resource is possessed by a single firm: resource monopoly 2.States grant to a single firm the exclusive right to produce a good (patents, privatives): legal monopoly 3.The structure of production costs makes a single firm more efficient than a multitude of small producers: natural monopoly

Natural monopoly: the average total cost curve continuously decreases instead of having the usual U-form. If production were divided among many firms, each of them could produce a lesser quantity at higher average total costs. Cases - water distribution - railway network

A fundamental characteristic of a monopoly firm is its capacity to influence market prices. Under perfect competition the price is given. The demand curve of a competitive firm corresponds to a infinitesimal share of the market and is perfectly elastic. That of the monopoly firm coincides with the demand curve of the whole market and is normally downwards sloping.

The demand curve (reflecting buyers’ willingness to pay) represents the only constraint to the monopolist’s market power. If the monopolist increases the price of his/her good, consumers buy a lower quantity and vice versa if he or she diminishes the price.

Total, average and marginal revenues of a monopolist QuantityPrice Total revenue Average revenue Marginal revenue QP RT = P  Q RMe = RT/Q RM=  RT/  Q

Graphically: Average revenue = Price Marginal revenue: always lower than average revenue

Gola of the monopolisty firm is always profit maximisation. The usual condition is: RM = CM. NB: P > RM Under competition, on the contrary: P = RM

The monopolist’s profit is always RT – CT or P – CMeT  Q.

The demand curve reflects willingness to pay The monopolist’s marginal cost curve reflects his/her costs. The socially efficient quantity corresponds to the intersection between the marginal cost curve and the demand curve Do monopolies diminish social welfare? Economists answer in the affirmative: monopolies entail a deadweight loss for consumers.

As the monopoly firm maximises profits when RM = CM, it produces a lower quantity than the socially efficient one.

Observe the triangle above the price line: it is the consumer surplus when the price is unique. The triangles A and B represent the deadweight loss. A is the consumer’s loss of surplus, and B is the producer’s loss of surplus (more than compensated by the monopoly profits represented by the rectangle C) C A B

Let us suppose that the monopolist manages to apply different prices to different groups of customers: small purchases, normal purchases, Large purchases: price discrimination Effect 1. The surplus of small buyers is reduced, the monopolist’s Profit increases

Let us suppose that the monopolist manages to apply different prices to different groups of customers: small purchases, normal purchases, Large purchases: price discrimination Effect 2. Buyers that formerly renounced to buy large quantities Now decide to buy them. The deadweight loss is diminished The monopolist’s profits increase. Social welfare increases!

Limit case: if the monopolist manages to invent a continuous series of classes on which to apply price discrimination, we attain a total elimination of the consumer surplus and of deadwieght loss and the monopolist transforms into profit the whole area above the Average cost curve and below the demand curve.  Perfect price discrimination NB. Social welfare is maximum!!!

An oligopoly market is a market in which there are a few firms, each exerting, by its choices, a considerable influence on the profits of other firms. Oligopoly is a kind of imperfect competition, in which a few firms sell similar products (oil, tennis balls) It is different from monopoly competition, in which many firms sell similar although non identical products (CDs, videogames).

If oligopoly firms cooperate, they act like a monopoly firm and share profits. Very often, however oligopoly firms are forced to compete among them. In this case they adopt a strategic behaviour: they make their choice according to the choices of competitors, in order to increase their share of the market. But this generates negative effects for all competitors (reduction of profits). The “game theory” studies the strategic behaviour of oligopoly firms.

Example of “non cooperative game”: prisoner’s dilemma. Let us suppose that Bonnie e Clyde are arrested. At the moment of arrest they have on them illegal arms. The punishment for this crime is 1 year of imprisonment. They are interrogated in different rooms at the same time. The magistrate proposes to each of them the same deal: if he or she confesses and denounces her or his accomplice, the illegal possession of firearms will be remitted and he or she will be liberated. The accomplice will be condemned to 20 years of imprisonment. If both confess, the punishment will be 8 years (partial remittance for confessing).

The following is the “matrix of payoffs”: The strategy consisting in confessing is called “dominant strategy”. It is advantageous for both, ignoring the choice of the accomplice. If they could communicate, the would cooperate and choose not to confess.. Clyde’s decisions Bonnie’s decisions ConfessNot to confess Confess 8 years : 8 yearsliberated : 20 years Not to confess 20 years : liberated1 year : 1 year

This example shows that oligopoly companies have an interest in making secret (“trusts”) or explicit (“cartels”) agreements, in order to cooperate and keep high profits. An example is OPEC. Another example: oil producing countries: Saudi Arabia’s decisions Iran’s decisions High productionLow production High production 40 billion € : 40 billion €60 billion € : 30 billion € Low production 30 billion € : 60 billion €50 billion € : 50 billion €