Market Structures Importance Importance Importance Importance Pure Competition Monopolistic Competition Oligopoly Monopoly Number of Firms Many small Many small A few large one Considers action or reaction of other firms Importance Diff or Homog Product type Homogeneous Differentiated one Need to stress differences? Importance Barriers to Entry none none large large Long run profits possible? Importance Price Taker/Maker taker taker/seeker maker maker Importance Ability to influence market price? Non-price Competition no yes yes yes As important as price? Importance

Characteristics? Perfect Competition 1. Many Sellers 2. Identical Products 3. Easy Entry and Exit 4. No Non-Price competition 5. SR profits/losses, no LR profits 6. Price Taker

Perfect Competition Market supply & demand determine price. The firm’s demand will be perfectly elastic. Firms can sell as much as they want at P Above P, they lose business Below P they lose revenue. Output Price Firm Output Price Market Market demand Firms must take the market price Market supply P P Firm’s demand

Marcia’s Marginal Cost and Marginal Revenue $120 110 100 90 80 70 60 50 40 30 20 10 Losses Marginal Cost and Marginal Revenue Profits 1 2 3 4 5 6 7 8 Number of Cakes

Long-run Equilibrium Ssr MC ATC d1 D The two conditions necessary for long-run equilibrium in a price-taker market are depicted here. The quantity supplied and the quantity demanded must be equal in the market, as shown below at P1 with output Q1. At the price established in the market, firms in the industry earn zero economic profit Firm Output Price Market P1 D Ssr Q1 Price MC ATC P1 d1 Output q1

Earn economic profit MR > ATC MR Normal Profit MR = ATC Output Price Firm MC ATC AVC Short Run Profits Earn economic profit MR > ATC MR P3 Normal Profit MR = ATC Short Run Losses Firm covers AVC, but not AFC: MR < ATC, but MR > AVC Shut Down Firm can’t cover AVC, minimize losses by shutting down MR < AVC

The Supply Curve The marginal cost curve (MC) is the firm’s supply curve. Below MC = AVC, the firm will shut down Output = 0 below P1,, At P2 MR = MC at q2. At P3 MR = MC at q3. Output Price Firm MC ATC AVC MC is the firm’s Supply Curve P3 P2 P1 q1 q2 q3

An Increase in Market Demand Consider the market for toothpicks. A new candy that sticks to teeth causes the market demand for toothpicks to increase from D1 to D2 … market price increases to P2 … shifting the firm’s demand curve upward. At the higher price, firms expand output to q2 and earn short-run profits. Economic profits will draw competitors into the industry, shifting the market supply curve from S1 to S2. Firm Market Price Price S1 MC S2 D2 ATC P2 d2 P2 P1 d1 P1 D1 Output Output q1 q2 Q1 Q2

The Adjustment S1 MC S2 ATC d2 d1 Slr d1 D1 D2 After the increase in market supply, a new equilibrium is established at the original market price P1 and a larger rate of output (Q3). As the market price returns to P1, the demand curve facing the firm returns to its original level. In the long-run, economic profits are driven down to zero. Firm Market Price Price S1 MC S2 ATC P2 d2 P2 d1 Slr P1 d1 P1 D1 D2 Output Output q1 q2 Q1 Q2 Q3

A Decrease in Demand S2 S1 MC ATC d1 d2 D2 D1 If, instead, something causes market demand for toothpicks to decrease from D1 to D2 … the market price falls to P2 shifting the firm’s demand curve downward, leading to a reduction in output to q2. The firm is now making losses. Short-run losses cause some competitors to exit the market, and others to reduce the scale of their operation, shifting the market supply curve from S1 to S2. Firm S2 Market Price Price S1 MC ATC D2 P1 d1 P1 d2 P2 P2 D1 Output Output q2 q1 Q2 Q1

The Adjustment: S2 S1 MC ATC Slr d1 d1 d2 D2 D1 After the decrease in market supply, a new equilibrium is established at the original market price P1 and a smaller rate of output Q3. As the market price returns to P1, the demand curve facing the firm returns to its original level. In the long-run, economic profit returns to zero. Note the long-run market supply curve is flat Slr. Firm S2 Market Price Price S1 MC ATC Slr P1 d1 d1 P1 P2 d2 P2 D2 D1 Output Output q2 q1 Q3 Q2 Q1

1. One Seller 2. One Product 3. Blocked Entry (and exit?) 4. Non-Price competition 5. LR profits/losses 6. Price Maker (to maximize profits)

Barriers to Entry economies of scale government licensing Patents 4. control over an essential resource

A Natural Monopoly Graph Average Cost One firm producing Q1 has average cost C1 If two firms share the market, each produces Q0.5 and has average cost C0.5 If three firms share the market, each produces Q0.33 has average cost C0.33 C0.33 C0.5 C1 ATC Q Q0.33 Q0.5 Q1

Marginal Revenue of a Monopolist Initial price P1 & output q1. Total revenue (TR) = P1 * q1. Price Reduction in Total Revenue 1. As price falls from P1 to P2, output increases from q1 to q2, two conflicting influences on TR. Increase in Total Revenue P1 1. TR will rise because of an increase in the number of units sold (q2 - q1) * P2. P2 2. TR will decline [(P1 - P2) * q1] as q1 units once sold at the higher price (P1) are now sold at the lower price (P2). d Depending on the size of the shaded regions, total revenue may increase or decrease. MR Quantity/time q1 q2

The Welfare Loss from a Monopoly The welfare loss from a monopoly is represented by the triangles B and D The rectangle C is a transfer of surplus from the consumer to the monopolist The area A represents the opportunity cost of diverted resources, which is not a loss to society P MC PM C D PPC B D A MR Q QM QPC

Price and Output Under Monopoly Quantity/time Expand output as long as MR > MC. (P goes down) MC Economic profits Output level q will result … with price determined by the height of the demand curve at that level of output, P. ATC A P B At q the average total cost per unit for that scale of output is C. C d MR < MC As P > C (price > ATC) the firm is making economic profits equal to the area PABC. MR > MC MR q

When a Monopolist Incurs Losses Price Quantity/time A monopolist will set output equal to q, where MR = MC MC At this level of output, the price that the monopolist charges does not cover the average total cost of producing the output ( P < C ). ATC A C Short-run losses P B Whenever the ATC curve lies always above the demand curve, the monopolist will incur short-run losses. In this diagram the firm is making economic losses equal to the shaded area, CABP. d MR q

Regulation of a Monopolist An unregulated monopolist produces where MR = MC (Q0) and charge price P0. Price From an efficiency viewpoint, this output is too small and the price is too high. Average cost pricing Marginal cost pricing P0 average cost pricing The monopolist is forced to reduce its price to P1 the expand output to Q1. LRATC P1 MC 2. marginal cost pricing Force output to be expanded to Q2 where P = MC P = cost to produce Forces LR losses. P2 D MR Q0 Q1 Q2 Quantity/time

Price Discrimination Sellers may gain from price discrimination by charging: higher prices to groups of customers with more inelastic demand lower prices to groups of customers with more elastic demand Price discrimination generally leads to more output and additional gains from trade.

The Economics of Price Discrimination Consider a hypothetical market for airline travel where the Marginal Cost per traveler is $100. If the airline charges all customers the same price, profits will be maximized where MC = MR. Here the airline charges everyone $400 and sells 100 seats. This generates Net Operating Revenue of $30,000 or (total revenues) $40,000 – (operating costs) $10,000. Price $700 Net operating revenue ($300*100) = $30,000 $600 $500 $400 $300 $200 MC $100 MR D 100 Quantity/time Single price

The Economics of Price Discrimination By charging higher prices to consumers with less elastic demand and lower prices to those with more elastic demand it will increase net operating revenue. If the airline charges $600 to business travelers (who have a highly inelastic demand) and $300 to other travelers (who have a more elastic demand), it can increase its Net Operating Revenue to $42,000. Price Price Net operating revenue from business travelers ($500*60) = $30,000 $700 Net operating revenue ($300*100) = $30,000 $700 Net operating revenue from all others ($200*60) = $12,000 $600 $600 $500 $500 $400 $400 $300 $300 $200 $200 MC MC $100 $100 MR D D 100 Quantity/time 60 120 Quantity/time Single price Price Discrim.

Monopolistic Competition Firms face low entry barriers Differentiated Products -they face a downward sloping demand curve -no Long Run Profits -Non-price Competition Price Taker Many Small Firms

Product Differentiation Price-searchers produce differentiated products – products that differ in design, dependability, location, ease of purchase, etc. Rival firms produce similar products (good substitutes) and therefore each firm confronts a highly elastic demand curve. The goals of advertising are to increase demand and make demand more inelastic Advertising increases ATC The increase in cost of a monopolistically competitive product is the cost of “differentness”

Price and Output A profit-maximizing price searcher will expand output as long as marginal revenue exceeds marginal cost. Price will be lowered and output expanded until MR = MC The price charged by a price searcher will be greater than its marginal cost.

Price and Output: Short Run Profit A monopolistic competitor maximizes profits by producing where MR = MC, at output level q Price MC Economic Profits and charges a price P along the demand curve for that output level. ATC P At q the average total cost is C. C What impact will economic profits have if this is a typical firm? d Because the price is greater than the average total cost per unit (P > C) the firm is making economic profits equal to the area ( [ P - C ] * q ) MR Quantity/time q

Price and Output: Long Run Because entry and exit are free, competition will eventually drive prices down to the level of ATC. Price MC When profits (losses) are present, the demand curve will shift inward (outward) until the zero profit equilibrium is restored. ATC C = P P The price searcher establishes its output level where MC = MR. At q the average total cost is equal to the market price. Zero economic profit is present. No incentive for firms to either enter or exit the market is present. d MR Quantity/time q

Determining Profits Graphically: Monopolistic Competition MC ATCLosses ATCL ATCBreak even Losses ATCProfits Break even P ATCP A monopolistic firm can earn profits, losses, or break even in the short run D MR Q Q

Comparing Markets LR equilibrium for both. P = ATC and there are no economic profits. In monopolistic competition, firms face a downward-sloping demand curve, its profit-maximizing price exceeds MC. In Monopolistic Competition, output is too small to minimize ATC in long-run equilibrium. Price Quantity/Time Pure Comp Mono comp MC MC ATC ATC P2 P1 d d MR q1 q2

Comparing Price Taker Markets Even though the two markets have the same cost structure, the price in the monopolistic competitor’s market is higher than that in the price-taker’s market ( P2 > P1 ). Some consider this price discrepancy a sign of inefficiency; others perceive it as a premium society pays for variety and convenience (product differentiation). Price Quantity/Time Pure Comp Mono comp Price Price MC MC ATC ATC P2 d P1 d MR q1 q2

Characteristics? Oligopoly 1. Few Sellers 4/26/2017 Oligopoly Characteristics? 1. Few Sellers 2. Differentiated or Identical Products 3. Difficult Entry and Exit 4. Non-Price competition 5. LR profits/losses 6. Price Maker

Oligopolies are made up of a small number of firms in an industry In any decision a firm makes, it must take into account the expected reaction of other firms Oligopolistic firms are mutually interdependent Oligopolies can be collusive or noncollusive Firms may engage in strategic decision making where each firm takes explicit account of a rival’s expected response to a decision it is making 16-32

Empirical Measures of Industry Structure The concentration ratio is a firm’s percentage of total industry sales concentration ratio The Herfindahl index is the sum of the squared value of the a firm’s share in the industry Herfindahl index This gives more weight to firms with large market shares than does the concentration ratio measure

Game Theory or Strategic Interaction A non-cooperative game is a game in which each player is out for him- or herself and agreements are either not possible or not enforceable Cooperative games are games in which players can form coalitions and can enforce the will of the coalition on its members Sequential games are games where players make decisions one after another, chess, for example Simultaneous move games are games where players make their decisions at the same time as other players, for example, the prisoner’s dilemma

Strategic Decision Making Models 1. Payoff Matrix high low A B $59 $57 high $60 $55 C D $55 $50 low $69 $58

2. Kinked Demand Curve . price elastic Current Price and Quantity P TR inelastic P TR MC1 D=AR MC2 MC3 Q quantity MR

Collusion Agreement to fix prices and/or divide market share - helps reduce uncertainty - increases profits - keeps entry difficult

1. Overt Collusion 2. Covert Collusion Types a. Formal Agreement to set Prices b. OPEC 2. Covert Collusion a. Secret agreements b. Electric switch makers in the 50s

3. Gentlemen’s Agreements Types 3. Gentlemen’s Agreements a. Agree on price then use non-price competition b. Types of agreements 1) Price Leadership - GM -dominant firm set price -others follow 2) Cost-Plus Pricing - Set price based on ATC at 85% capacity

Obstacles to Collusion 1. More firms, more likely to cheat 2. Firms may cheat in non-price ways – free services 3. Requires barriers to remain high 4. Unstable demand/business cycles 5. Illegal - use Gentlemen’s agreements 6. Difficult to hold the price

Comparison of Market Structures Monopoly Oligopoly Monopolistic Competition Perfect Competition No. of firms One Few Many Almost infinite Barriers to entry Significant None Pricing decisions MC = MR Strategic pricing MC = MR = P Output decisions Most output restriction Output restricted Output restricted, product differentiation No output restriction Interdependence No competitors Interdependent decisions Each firm independent LR profit Possible P and MC P > MC P = MC