Market Structures Prof. Patrick Gougeon, ESCP-EAP  Market analysis: methodology  Perfect competition vs monopoly  Imperfect markets  special issues

Market regulation A place where supply meets demand price quantity SupplyDemand Market price A voting place A place where inefficiency is sanctioned A place where information are available for firms to allocate resources efficiently Prof. Patrick Gougeon, ESCP-EAP

Market structures: classification  Normative approach Perfect competition versus monopoly  Normative approach Perfect competition versus monopoly  Positive approach Oligopoly (few firms); monopolistic competition,...  Positive approach Oligopoly (few firms); monopolistic competition,... Prof. Patrick Gougeon, ESCP-EAP

Analysing market equilibrium individual demand Market demand Competition (pure competition/monopoly; oligopoly, monopolistic competition) Demand to the firm CostsPrice strategy (based on profit maximisation) Prof. Patrick Gougeon, ESCP-EAP

Market structures analysis A basic principle: Profit Maximisation Profit:   = R(q) - C(q)  = [ P(q) x q ] - C(q) Demand to the firm Max  :  ’ q = Rm - Cm = 0 Rm = Cm Marginal income = Marginal Cost Rm = Cm Marginal income = Marginal Cost To analyse a particular market structure we need to specify the properties of the demand to the firm Prof. Patrick Gougeon, ESCP-EAP

Market structures analysis A basic principle: Profit Maximisation Cost, Profit Quantity Total Cost Total Income Quantity Profit  max Cm Rm  max Break even q* Prof. Patrick Gougeon, ESCP-EAP

Perfect competition  Atomicity  Free entry  Transparency  Homogeneity  Factors mobility  Definition Prof. Patrick Gougeon, ESCP-EAP

Perfect competition  Mecanismes price quantity Supply (N firms) Demand Market price imposed to all firms demand function: P = P°, Rm = P° Cost, price quantity MarketFirm Average cost individual supply (marginal cost Cm = P) Supply (N+n firms) QNQN qNiqNi Long term market price (price = average cost = Cm) Q N+n q N+n i = N q N i margin Long term market price equal to the minimum average cost, the lowest that can prevail  The highest possible satisfaction for consumers  No profit !(Return on capital invested is at a « normal rate ») Free entry P° P* Prof. Patrick Gougeon, ESCP-EAP

Monopoly Demand to the firm = Market demand P = - a q + bR(q) = P x q = - a q 2 + b q Rm = - 2 a q + b price quantity Demand: - a q + b P* Rm: - 2 a q + b Cm P* > Cm Rm = Cm Average cost  Perfect competition P min = Cm P maxMonopoly P P - Cm measure of competition intensity q* Prof. Patrick Gougeon, ESCP-EAP

Market regulation: some issues …..but issues to be discussed.  A static approach (innovation…)  Ethical issues (environmental protection, health care…)  The issue of cultural goods and services (education, art…) Competition as a source of efficiency…...  optimal resources allocation  eviction effect Prof. Patrick Gougeon, ESCP-EAP

Imperfect markets  Atomicity  Free entry  Transparency  Homogeneity  Factors mobility Monopoly Duopoly OLIGOPOLY Prof. Patrick Gougeon, ESCP-EAP

Imperfect markets  Atomicity  Free entry  Transparency  Homogeneity  Factors mobility MONOPOLISTIC COMPETITION Prof. Patrick Gougeon, ESCP-EAP

Imperfect markets: Oligopoly P° q° Let’s start from the current position: P°, q° Few firms competing on the market 1/ Price increase ? Competitors would not follow, demand is elastic 2/ Price reduction ? Competitors would follow, demand is inelastic Demand to the firm Rm Cm Price stability is most likely Rm = Cm Demand to the firm ? Prof. Patrick Gougeon, ESCP-EAP

Imperfect markets: measures of concentration C4: Market share of the 4 largest suppliers H = 1/Pi2Pi2 n firms: i = 1,….n P i market share of firm i 100% Total market share Proportion of of firms 100% (increasing size) 30% 90% 90% of total population represents only 30% in terms of market share Lower concentration ratio Herfindahl-Hirschman Index Prof. Patrick Gougeon, ESCP-EAP

Imperfect markets: measures of concentration I II Prof. Patrick Gougeon, ESCP-EAP

Imperfect markets: Entry Barriers  Regulatory barriers  Brand and reputation  Scale and experience  “lock in” and switching cost  Upstream and downstream control  Regulatory barriers  Brand and reputation  Scale and experience  “lock in” and switching cost  Upstream and downstream control A remark about “contestable markets” If there exist high barriers to entry, then existing firms can maintain an abnormal profit. However, if new entrant could come in with little difficulty, existing firm will behave more like competitive firms. In this latter case the market is said to be “contestable”, with a price not far from what would prevail with pure competition though concentration is high. Prof. Patrick Gougeon, ESCP-EAP

Imperfect markets: monopolistic competition Competion and product differenciation P° q° Rm The short term equilibrium is similar to a monopoly situation Demand to the firm ? price quantity margin Average Cost Entry of new competitors ? Downwards schift of the demand curve, leading to zero profit (for the same price, demand is now lower) As compared with perfect competition, the price is higher (over the minimum long term average cost) New entries There is no perfect substitute, therefore the demand is not perfectly elastic Prof. Patrick Gougeon, ESCP-EAP

About differentiation and advertising Prof. Patrick Gougeon, ESCP-EAP P° q° Demand to the firm Don’t compare Pay the price…just the price

Imperfect markets: Monopoly with price discrimination A single supplier and two separate markets Price, cost q Market IMarket IIFirm Aggregate Demand to the firm Rm Cm q1 q2 Q = q1 + q2 P1 P2 Rm1 = Rm2 = RmT = Cm Prof. Patrick Gougeon, ESCP-EAP

Imperfect markets: Monopoly with price discrimination Rm 1 = Rm 2 = Rm T = Cm Prof. Patrick Gougeon, ESCP-EAP Market I Demand curve: p = - q Therefore, Rm 1 = - 2q Market II Demand curve: p = - q Therefore, Rm 2 = - 2q Price = 240 Price = 120 Is it the best pricing strategy ? Quantity sold: q 1 = 160 Marginal income: Rm 1 = 80 Quantity sold: q 2 = 80 Marginal income: Rm 2 = 40 NO because Rm 1, Rm 2, and Cm differ Cm = 0.5 q q = q1 + q2 = 240therefore, Cm = 120 The best solution is obtained for p 1 = 250 ; q 1 = 150 and p 2 = 150 ; q 2 = 50 Rm 1 = Rm 2 = Rm T = Cm = 100

Imperfect markets Monopoly behaviour: bundling * Type of consumersWord processorSpreadsheet Type A Type B Willingness to pay for software components If the marginal cost is low, profit maximisation will lead to propose each component at 100 ….But if both components are sold as a bundle, the firm can propose 220 for it ! Which pricing strategy do you propose ? See Hal R. VARIAN, Intermediate Microeconomics, 5th edition, Norton, p 444 Prof. Patrick Gougeon, ESCP-EAP