market structure lecture slides

Firms and How They Operate II

MARKET STRUCTURES

Lecture Outline A. Types of Market Structure and their Characteristics B. Equilibrium in the Short Run and Long Run - Perfect Competition - Monopoly Appendix: Arguments for and against patents - Monopolistic Competition - Oligopoly C. Price Discrimination Appendix - Peak Load Pricing D. Comparison and Analysis of the 4 Market Structures

PJL ☺

What is Market Structure?

Characteristics of a market or an industry that affect the firms’ behaviour and level of performance • • • •

Characteristics determining the market structure How firms compete in their respective market structures Other forms of market behaviour (e.g., price discrimination) Comparison and analysis of the four market structures

Characteristics

determining market structure

Number of buyers/sellers

What is Market Structure?

Useful to think of it as a SPECTRUM…

Perfect Competition

Monopolistic Competition

Oligopoly

Characteristics

Monopoly

determining market structure

Barriers to entry

relative to market size

Nature of products Knowledge of product

Barriers to entry are anything that prevents or impedes the entry of firms into an industry and thereby limits the amount of competition faced by existing firms

NOOB Barriers to entry

1

Characteristics

determining market structure

Perfect Competition

Barriers to entry Artificial •

Number of buyers/sellers Natural

•

Contrived barriers (e.g., cartel, mergers and acquisitions)

•

Legal barriers (e.g., patents, copyrights, tariffs)

• •

Price war Non-price competition - Product differentiation - Advertising

Very huge sunk costs natural monopoly

•

Exclusive control of essential raw materials

Large number of buyers and sellers No one can influence price

Refer to Sloman (6th ed.) pages 166 to 167 for more information

Perfect Competition

Perfect Competition

Nature of products

Knowledge of product

Homogeneous product

Perfect knowledge

No preference for product of any one firm

Buyers will not purchase product at higher price than the prevailing market price

Perfect Competition

Perfect Competition

Number of buyers/sellers

PC firm is a PRICE TAKER

+

Price

+

P

Nature of products Knowledge of product PC firm is a PRICE TAKER

0

DD = AR = MR

Qty

P = AR = MR for the PC firm

2

Perfect Competition

Perfect Competition th wi p EXAMPLES u n me o w s ! o C ur ple yo am • Agricultural products ex

Barriers to entry

No barriers to entry Perfect factor mobility

• Stock market

No transaction costs Firms can only make normal profits in the LR

• Newspaper vendors

Perfect Competition The model of perfect competition is built on very strict assumptions, and real-world examples are rare, if at all existent.

However, it is an ideal yardstick against which real-world market structures are compared.

H3:

Monopoly Number of buyers/sellers

Single producer

firm = industry

can influence either PRICE or OUTPUT, but not both

Is a theory/model whose assumptions are not observed in the real world necessarily useless?

Price setter!

Monopoly

Monopoly Nature of products

Monopoly’s demand curve P

Price

NOTE: 1. AR > MR at all levels of output except first unit 2. Gradient of MR = 2 x Gradient of AR

P 2

P

1

Demand = AR MR q2

q1

Qty

No close substitutes

I’m unique!

very low CED and PED compared to other market structures

Knowledge of product

Consumers have imperfect knowledge

3

Monopoly Barriers to entry

Monopoly EXAMPLES

th wi p u n me o w s ! o C ur ple yo am ex

Substantial barriers to entry

• StarHub’s EPL coverage

Firm can make supernormal profits even in the LR

• SMRT for NS and EW MRT lines

Monopoly Definition of monopoly depends on how narrowly the industry is defined e.g., pay-TV industry vs EPL coverage http://www.channelnewsasia.com/stories/singaporelocalnews/view/289385/1/.html

SingTel StarHub StarHub

http://www.channelnewsasia.com/stories/singaporebusinessnews/view/243156/1/.html

http://www.channelnewsasia.com/cna/analysis/031104_competition.htm

Monopolistic Competition Number of buyers/sellers

Large number of buyers and sellers each firm has insignificantly small share of the market actions unlikely to affect its rivals’

Monopolistic Competition Nature of products

Differentiated Mouse Trapsproducts firms have some degree of control over its own prices but because of close substitutes, relatively price elastic downwardsloping demand curve

Monopolistic Competition Knowledge of product

Imperfect knowledge Barriers to entry

No / Low barriers to entry

4

Monopolistic Competition

Also…

Monopolistic Competition EXAMPLES

• No industry demand curve • Unlikely for retaliation by rivals • Unlikely for collusion

• Hair salons • Restaurants • Retail shops (?)

Oligopoly

Oligopoly

Number of buyers/sellers

Small number large firms relative to market size

th wi p u n me o w s ! o C ur ple yo am ex

Nature of products

Homogeneous/Differentiated Knowledge of product

Interdependent behaviour

Imperfect knowledge

Oligopoly Barriers to entry

High barriers to entry

Oligopoly EXAMPLES

th wi up e wn m !

Co ur o ples o y am ex

• Petrol companies (in Singapore)

Firm can make supernormal profits even in the LR • Taxi companies (in Singapore)

5

Summary Number of buyers/sellers Nature of products Knowledge of product Barriers to entry

Equilibrium in SR & LR Perfect Competition MARKET STRUCTURE

Recap • Under perfect competition, we assume: – Large number of buyers and sellers – Homogeneous product – Perfect knowledge – No barriers to entry

• Therefore, all firms are price takers and the demand curve is perfectly price elastic

Recap • If firm sells its goods above the set market price, consumers will simply buy from any other firm • No incentive to lower price either, since the seller can sell all he wants at the prevailing market price • Therefore, no price competition • Also no non-price competition either, since homogeneous product

Recap Price determined by mkt P Mkt Ss

P Individual firms must take the mkt price P*

P*

Indv’s Dd Mkt Dd Qty

Qty Market

Individual Firm

• Individual firms can sell all they want at the prevailing market price, P*

SR Equilibrium • Conditions for profit-maximisation – MC = MR – MC is rising

6

SR Equilibrium

SR Equilibrium

• Conditions for profit-maximisation

• In the SR, PC firms can make – Supernormal profits – Normal profits – Subnormal profits

MR > MC

MR > MC

MC > MR

SR Equilibrium

SR Equilibrium

• In the SR, PC firms can make

• In the SR, PC firms can make

– Supernormal profits

TR = ?

ATC

B

TC = ?

P = AR = MR C

ATC

MC = MR

TC = ?

P .

MC

Price

MC = MR

TR = ?

TR > TC

– Normal profits MC

Price

A

P

TR = TC

B P = AR = MR

Try on your own!

• Normal profits • Subnormal profits

Output

q

0

.

.

SR Equilibrium MC

MC = MR

TC = ?

TR < TC

ATC

A . C P

B

P = AR = MR

Output .

0

Output

• In the LR, PC firms can only make normal profits, because of the assumption of no barriers to entry

– Subnormal profits Price

q

LR Equilibrium

• In the SR, PC firms can make

TR = ?

0

– If supernormal profits are made, firms enter the industry with ease and compete in the industry supernormal profits eroded – If subnormal profits are made, firms leave the industry with ease the remaining firms return to normal profits

q

7

LR Equilibrium S0 P

LR Equilibrium

MC S1

p

ATC P0

p0

P1

p1

d0

• In the LR, the equilibrium for the PC firm is at the output level where LRAC = LRMC = MR = AR LRMC

p

d1

LRAC

D p* Q0 Q1 Market

MR = AR

qty

Qty q1 q0 Individual Firm

SUMMARY

q*

• In the LR, the firm is operating at its minimum efficient scale

Equilibrium in SR & LR

• In the SR, firms can make supernormal, normal and subnormal profits.

• In the LR, firms can only make normal profits

MOooooNOPOLY

Recap

Recap Monopoly’s demand curve P

Price

• Under monopoly, we assume: – Single producer – No close substitutes for product – Imperfect knowledge – Significant barriers to entry

• Therefore, all firms are price setters and the demand curve is downward-sloping

P 2

P

1

Demand = AR MR q2

q1

Qty

• Monopoly can influence either price or output, but not both

8

Recap

SR Equilibrium

• Firm’s DD curve = Industry DD curve • Monopoly is the only producer of the good no price competition at all • Contingent on the maintenance of barriers to entry

SR Equilibrium

• Conditions for profit-maximisation – MC = MR – MC is rising

SR Equilibrium

• Conditions for profit-maximisation

• In the SR, the monopoly can make

MC > MR

MR > MC

– Supernormal profits – Normal profits – Subnormal profits

SR Equilibrium

SR Equilibrium

• In the SR, the monopoly can make

• In the SR, the monopoly can make

– Supernormal profits Price

– Normal profits

MC

MC = MR

Price

ATC

MC = MR

MC

TR = ?

TR = ?

A

TC = ?

P

TC = ?

ATC

A P

TR > TC

TR = TC C

B AR MR

AR

Begin with the end in mind

MR .

0

q

Output .

0

q

Output

9

SR Equilibrium

SR Equilibrium

• In the SR, the monopoly can make MC

– Subnormal profits

ATC

MC = MR

Price

TR = ?

MC = MR

Loss if continue production

A C

TC = ?

• In the SR, the monopoly will continue production only when TR ≥ TVC MC

ATC

Price A

AVC

C

P

P B

B

= CABP

TR < TC

E D

Loss if shut down AR

Output .

0

AR

= TFC

MR

q

LR Equilibrium • In the LR, the monopoly can make supernormal profits, as long as it is able to keep potential firms from entering the industry • In the LR, the monopoly will continue production only if it can at least make normal profits

Maintain Barriers to Entry • Economies of scale – Usually new firms begin operations on a smaller scale higher average cost – Existing monopoly enjoy substantial internal economies of scale lower average cost Get lost!

– Can even lower price of product

MR

= CADE

Output .

0

q

Maintain Barriers to Entry • Economies of scale • Gaining Control • Tactics to eliminate competition

Maintain Barriers to Entry • Gaining Control – Convince consumers that its product is unique and has no close substitutes by • Advertising • R&D • Legal protection

10

Maintain Barriers to Entry • Tactics to eliminate competition – Price cutting – Merger and acquisition

SUMMARY • In the SR, the monopoly can make supernormal, normal and subnormal profits.

• In the LR, the monopoly must at least make normal profits • The monopoly can make supernormal profits in the LR if it is able to maintain significant barriers to entry

Recap

Equilibrium in SR & LR

• Under monopolistic competition, we assume:

Monopolistic Competition

Recap • No market demand curve • Firms have some degree of monopoly power over its products • Contingent on product differentiation • Non-price competition

– – – –

Many buyers and sellers Differentiated products Imperfect knowledge No / Low barriers to entry

Product Differentiation • Real physical differences

11

Product Differentiation • Imaginary differences

• Differences in conditions of sale

Product Differentiation Increase demand

Product Differentiation

GIVE ME MORE!!!!!

SR Equilibrium • Conditions for profit-maximisation – MC = MR – MC is rising

I only want this!!!!!

Demand more price inelastic

SR Equilibrium • In the SR, the MPC firm can make – Supernormal profits – Normal profits – Subnormal profits

SR Equilibrium • In the SR, the MPC firm can make – Supernormal profits Price

MC = MR

MC

TR = ?

Same as monopoly!

TC = ?

ATC

A P

TR > TC C

B

AR

Begin with the end in mind

MR .

0

q

Output

12

SR Equilibrium

SR Equilibrium

• In the SR, the MPC firm can make

• In the SR, the MPC firm can make

MC

MC = MR

– Normal profits

Price

ATC

MC

– Subnormal profits

MC = MR

ATC

Price

TR = ?

TR = ?

A C

A P

TC = ?

TC = ?

TR = TC

P B

TR < TC AR

AR

MR

.

MR Output

q

0

SR Equilibrium MC = MR

ATC

Price A

AVC

C P B

= CABP

q

0

LR Equilibrium

• In the SR, the MPC firm will continue production only when TR ≥ TVC MC Loss if continue production

Output .

E D

• In the LR, the MPC firm can only make normal profits – Supernormal profits new firms enter (ease of entry) – Subnormal profits existing firms exit (ease of exit)

Loss if shut down AR

= TFC

MR

= CADE

Output .

0

q

LR Equilibrium

LR Equilibrium

• Supernormal profits – new firms enter – potential substitutes – consumers have wider range of products to choose from – dd falls and becomes more price elastic for each firm’s product – normal profits in the LR

MC = MR

MC

MC = MR

Price

Normal Profits in the LR

ATC

A P

MR1

AR2

AR1

MR2

.

0

q

Output

13

SUMMARY

Equilibrium in SR and LR

• In the SR, the MPC firm can make supernormal, normal and subnormal profits.

• In the LR, the MPC firm can only make normal profits

Oligopoly

Recap • Under oligopoly, we assume: – Small number of large firms relative to market size

– Homogeneous/Differentiated – Imperfect knowledge – High barriers to entry

Models of Oligopoly Impossible to predict effect on a firm’s sales without making assumptions about reactions of other firms

Recap • Interdependent behaviour – Each firm has significant share of market

• Barriers to entry – varies depending on type of industry

Models of Oligopoly

Different assumptions made = different predictions

No single generally accepted theory of oligopoly

VS

Collusive model

Competitive model

14

Collusion

Collusion

Reduce unpredictability of rivals’ reactions

formal

informal/tacit

Cartel

Price leadership

People of the same trade seldom meet together, even for merriment or diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. ☺ Adam Smith

Dominant Price Leadership •

Act as one to determine price by controlling combined output

•

Predetermined market share

•

Incentive to cheat

Barometric Leadership

Competition

Competition Kinked Demand Curve

Game Theory Prisoners’ Dilemma

Firm will not match each other’s price increase perceive a price elastic demand

Price

What should Ali and Darren do?

Ali

Darren

Darren

confess

not confess

Each jail 12 mths

Ali jail for life Darren jail 3 mths

confess

Firms will match each other’s price reduction perceive a price inelastic demand

H3 syllabus!

MR

Ali not confess

Darren jail for life Ali jail 3 mths

Each jail 24 mths

D = AR Quantity

Sloman 6th ed. pg 193

Competition

Region of indeterminacy

Competition

Source:

Kinked Demand Curve

http://www.tutor2u.net/economics /content/topics/monopoly/kinked_ demand.htm

Kinked Demand Curve Price MC1 MC2 MC3

Significance of region of indeterminacy Should MC fluctuate within this region, firm will absorb higher costs

MR Q*

D = AR

same profit-maximising level

Quantity

15

Competition Kinked Demand Curve Offers some insight as to why prices in oligopoly tend to be rigid (“sticky”) However, • Model does not explain how the prices are set in the first place • Price stability could be due to other factors Menu costs Fear of harming firm’s image

Competitive Behaviour

Competitive Behaviour Price War • Usually firm will wage such a war only if it has costs of productions which are significantly lower than its rivals • When there is considerable excess capacity in the industry OR when new potential rival firms appear • Undercut prices to force rivals out may need to sustain SR losses • Survivors larger share of market

Competitive Behaviour

NonNon-Price Competition

NonNon-Price Competition

• Advertising

• Advertising • Promotions

Buy One Get One Free

Competitive Behaviour

Competitive Behaviour

NonNon-Price Competition

NonNon-Price Competition

• Advertising

• Advertising

• Promotions

• Promotions

• Product innovation

• Product innovation • Brand proliferation Firm produces lots of brands to saturate the market and leave no gap for rivals

16

Competitive Behaviour

Competitive Behaviour

NonNon-Price Competition

NonNon-Price Competition

• Advertising

• Advertising

• Promotions

• Promotions

• Product innovation

• Product innovation

• Brand proliferation

• Brand proliferation

• Market segmentation

• Market segmentation

Niche market

• Process innovation Reduce average costs

Summary • • • •

Interdependent behaviour Compete «=» Collude Kinked demand curve Price and non-price competition

NOTE: Price Discrimination Self Study

17