Download monopolistically competitive.

Market Structure: Perfect
Competition, Monopoly and
Monopolistic Competition
Slide 1
• What is Market Structure?
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»
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Market structure is the competitive environment.
Number of buyers and sellers.
Potential entrants.
The degree of mobility of resources - Barriers to entry
and exit, etc.
» Type of product bought and sold
» The degree of knowledge (economic agents)
• Vital Role of Potential Entrants
» Competition comes from actual and potential
competitors.
» Potential entrants often affect price/output decisions.
Slide 2
Factors that Shape the Market
Structure Environment
• Product Differentiation
» R&D, innovation, and advertising are important in
many markets.
• Production Methods
» Economies of scale can preclude small-firm size.
• Entry and Exit Conditions
» Barriers to entry and exit can shelter incumbents from
potential entrants.
• Buyer Power/Seller Power
» Powerful buyers can limit seller power
Slide 3
Pure (Perfect) Competition
Monopolistic Competition
Oligopoly
Monopoly
Less Competitive
More Competitive
Market Structure
Slide 4
The Strategy Process
Prerequisite
Knowledge
1. Customers
2. Competitors
3. Market Conditions
4. Capital Raising
5. Resource Availability
6. Socio-political
Constraints
Slide 5
The Strategy Process
Prerequisite
Knowledge
Components of the
Business Model
1. Target Market
1. Customers
2. Value Proposition
2. Competitors
3. Role of Value
3. Market Conditions
4. Revenue Sources
4. Capital Raising
5. Markets Defined
5. Resource Availability
6. Network Value
6. Socio-political
Constraints
7. Investment Required
8. Competitive Strategy
Slide 6
The Strategy Process
Prerequisite
Knowledge
Components of the
Business Model
Decisions
1. Target Market
1. Customers
2. Value Proposition
1. Products
2. Competitors
3. Role of Value
2. Prices
3. Market Conditions
4. Revenue Sources
3. Marketing Plans
4. Capital Raising
5. Markets Defined
4. Supply Chains
5. Resource Availability
6. Network Value
5. Distribution
Channels
6. Socio-political
Constraints
7. Investment Required
6. Projected Cash
Flows to Lenders
and Equity Owners
8. Competitive Strategy
Slide 7
Generic Types of Strategies to
Attain Sustainable Profits
• Product Differentiation Strategy
» So distinguish one’s products from the rest that the other
products do not appear to be close substitutes
» For example, Coca-Cola or Nestlé
• Cost-based Strategies
» Find ways to have the lowest cost (and provide the lowest
price) in the industry
» For example, Southwest Airlines & Dell Computers
• Information Technology Strategy
» Use IT capabilities to distinguish yourself from others
» For example, Allstate Insurance & GPS tracking to offer
lower insurance rates to those who don’t drive their best cars
to work
Slide 8
The Relevant Market Concept
• A market is a group of economic agents that interact in a
buyer-seller relationship. The number and size of the
buyers and sellers affect the nature of that relationship.
• A popular measure of concentration is the percentage of an
industry comprised of the top 4 firms. Similarly, the
market share held by the top 4 buyers is a popular measure
of buyer concentration.
• The relationship among firms is affected by:
a. the number of firms and their relative sizes.
b. whether the product is differentiated or standardized.
c. whether decisions by firms are independent or
coordinated (collusion).
Slide 9
Michael Porter’s Five Forces
of Competitive Advantage
The forces that determine competitive advantage are:
1. Substitutes (threat of substitutes can be offset by brands
and special functions served by the product).
2. Potential Entrants (threat of entrants can be reduced by
high fixed costs, scale economies, restriction of access to
distribution channels, or product differentiation).
3. Buyer Power (threat of concentration of buyers).
4. Supplier Power (threats from concentrated suppliers of key
inputs affect profitability).
5. Intensity of Rivalry (market concentration, price
competition tactics, exit barriers, amount of fixed costs, and
industry growth rates impact profitability).
Slide 10
Potential entrants
Substitutes
Value-price gap
Branded vs. generic
Sustainable
industry
profitability
High capital requirements
Economies of scale
Absolute cost advantages
High switching costs
Lack of access to distribution
channels
Product differentiation
Public policy constraints
Intensity of rivalry
Buyer power
Industrial concentration
Pricing tactics
Switching costs
Exit barriers
Cost fixity
Industrial growth rates
Buyer concentration
Overcapacity
Homogeneity of buyers
Potential of integration
Outside alternatives
Supplier power
Unique suppliers
Number of suppliers
Supply shortages or surplus
Degree of vertical integration
Slide 11
Break-even Sales Change Analysis
•
•
•
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The price-cost margin percentage (PCM) is defined as
PCM = ( P – MC )/P.
A price cut may help or hurt profitability depending on price
elasticities and price cost margins.
We can ask how much quantity must change after a price cut to
breakeven (from before the price cut)?
If we cut prices 10%, to breakeven the percentage change in quantity
(DQ/Q) must be large enough to satisfy the equation to breakeven:
PCM / (PCM – .10) < (1 + DQ/Q )
•
•
•
The larger is the price-cost margin percentage, the smaller will be the
necessary quantity response to justify cutting price.
If PCM is 80%, then .8/(.8-.1) = 1.14. Hence, a 10% cut in price
must be offset by at least a 14% increase in quantity to breakeven.
If PCM is only 20%, then .2/(.2-.1) = 2. Hence, a 10% cut in price
must be offset by at least a 20% increase in quantity to breakeven.
Slide 12
There is a continuum of market structures:
Pure (perfect) Monopolistic
Competition Competition
Oligopoly
Best
Monopoly
Worst
 Pure (Perfect) Competition assumes:
1.
2.
3.
4.
5.
6.
a very large number of buyers and sellers
Buyers and sellers are price takers
homogeneous product (standardized)
Economic agents have complete knowledge of all relevant market
information
free entry and exit (no barriers) - Perfect mobility of resources
Example: Stock Market
These assumptions imply several things about competitive markets,
including price equals marginal cost.
Slide 13
 Monopoly assumes:
1.
2.
3.
4.
5.
6.
Only one firm (seller) in the market area and many buyers
No close substitute for product
Low cross price elasticity with other products.
No interdependence with other competitors.
Substantial entry barriers
Significant barriers to resource mobility
»
»
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Control of an essential input
Patents or copyrights
Economies of scale: Natural monopoly
Government franchise: Post office
These assumptions imply that the monopoly price is well above marginal
cost.
Slide 14
3. Monopolistic competition assumes:
1.
2.
3.
4.
5.
A large number of firms, some of which may be
dominant in size
Differentiated products
Independent decision making by individual firms
Easy entry and exit – perfect mobility of resources
Example: Fast-food outlets
These assumptions imply several things about
monopolistic competition, including that the price in
the long run is equal to average cost.
Slide 15
 Oligopoly assumes:
1. Only a few firms in the market area
2. Products may be differentiated or undifferentiated
(homogeneous)
3. There is a large degree of interdependence with other
competitors
4. Barriers to resource mobility
5. Example: Automobile manufacturers
•
These assumptions imply several things about monopolies, including that the
monopoly price is well above marginal cost.
•
After going briefly over these four market structures, this chapter examines:
»
Pure Competition
» Monopolistic Competition
Slide 16
Pure Competition and
Monopolistic Competition
• Pure competition is a standard against which other
market structures are compared. The product is
perfectly undifferentiated.
• When there are many firms, but the product is
differentiated, the market is monopolistically
competitive.
» This brand competition may involve advertising
campaigns and large promotional expenditures to
stress often minor distinctions among products
2008 Thomson * South-Western
Slide 17
Price-Output Determination
Under Pure Competition
Competitive firms attempt to maximize profits.
Competitive firms cannot charge more than the market
price of others, since their product is identical to all
others.
Hence, competitive firms are price
takers.
Total revenue, TR, is P·Q, where price is given.
Therefore, marginal revenue, MR, is price, P.
Profit is total revenue minus total cost  = TR - TC).
Slide 18
Profit maximization implies that each firm produces an
output where Price = Marginal Cost (P = MC).
» To produce more than this quantity implies that
P < MC, which is not the most profitable decision.
» To produce less than where P=MC, implies that
P > MC, and the firm could increase profits by
expanding output.
• In short run, a competitive firm may earn
economic profits.
• In long run, entry pushes price down to the minimum
point of the average cost curve, so that economic
profits are zero.
Slide 19
A Competitive Market in the Short Run
1. If P = MC for each firm, then
each firm is doing what it
thinks maximizes profits.
Firms are in equilibrium.
2. Equilibrium for the industry
if: Demand equals Supply at
the going price
• In this example, the firm is
earning economic profits as
PSR > AC.
»
When both (1) & (2) occur, the market
is in a Competitive Equilibrium
MC
MC
PSR
AC
D
a firm
the industry
CAN EARN ECON PROFITS
IN THE SHORT RUN
Slide 20
Perfect Competition:
Price Determination
Slide 21
Perfect Competition:
Price Determination
QD  625  5P QD  QS QS  175  5 P
625  5P  175  5P
450  10P
P  $45
QD  625  5P  625  5(45)  400
QS  175  5P  175  5(45)  400
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Slide 22
Perfect Competition:
Short-Run Equilibrium
Firm’s Demand Curve = Market Price = Marginal Revenue
Firm’s Supply Curve = Marginal Cost
where Marginal Cost > Average Variable Cost
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Slide 23
Perfect Competition: Short-Run Equilibrium
Top panel
- d is the demand curve = P = MR
-The best level of output at point E, where
MC intersects with d or MR
-P = $45 and ATC = $35, profit = $10
Bottom panel
-At demand curve; d – the best level of
output is 3 and loss $10 (FE’) – P = $25 and
ATC = $35
-At point E’ the minimizes losses
-At point H – shut-down point
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Slide 24
A Competitive Market in the Long Run
• Industries which have
economics profits draw
entry and shift the MC1
curve out to MC2 where
there is no reason for
more firms to enter or
firms to exit the industry
• Price covers all cost, so in
the LR, P=AC which
means that Economic
Profits are zero.
MC1
MC
AC
MC2
entry
PLR
D
a firm
the industry
ZERO ECON PROFITS
IN THE LONG RUN
Slide 25
Long Run Competitive Markets
with external diseconomies of scale
$/barrel for oil
Brazilian
Ethanol
Mexican
Oil
Persian
Gulf Oil
D1
• As demand rises for products,
we find that inputs become
more expensive. The rising
cost is not due necessarily to
the productivity of the firms,
but higher prices for what they
purchase.
• One example is the rising price
for crude oil.
D2• As demand in the world
increase, the marginal seller of
oil is ever pricier.
Quantity in million barrels per day
Slide 26
Long Run Equilibrium in an
Increasing Cost Industry
AC2
Price
MC
AC1
Price
MC1
LRS
P2
P1
D2
Firm Level
D1
Industry Level
As demand shifts from D1 to D2, the price rises to P2
and the long run supply curve is upward rising. The cause
is the upward shift in AC that firms experience.
Slide 27
Perfect Competition:
Long-Run Equilibrium
Quantity is set by the firm so that short-run:
Price = Marginal Cost = Average Total Cost
At the same quantity, long-run:
Price = Marginal Cost = Average Cost
Economic Profit = 0
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Slide 28
Perfect Competition: Long-Run Equilibrium
-Point E* [P=MR=LMC=LAC (lowest)] – best level of output at P=$25, Q=4
-All profits and losses have been eliminated – because of free or easy entry into
the market
29
Slide 29
PROBLEM: The following is given:
For the industry:
QS = 3000 + 200 P and
QD = 13500 - 500 P
For the firm:
FC = 50
MC = 3 Q
FIND OPTIMAL output for this firm.
Slide 30
Answer: First find the equilibrium price.
Set D = S, where:
3,000 + 200 P = 13,500 - 500 P.
This implies:
700 P = 10,500 or:
10,500 / 700 = P = $15.
At this price, the firm produces where
P = MC, and because MC = 3Q
P = 15 = 3 Q
Q=5
Slide 31
Monopolistic Competition
• Many sellers of differentiated (similar but not
identical) products
• Limited monopoly power
• Downward-sloping demand curve
• Increase in market share by competitors causes
decrease in demand for the firm’s product
Product
Differentiation
Among Gas
Stations
Slide 32
Product Differentiation
• Differentiation occurs when consumers perceive that a
product differs from its competition on any physical or
nonphysical characteristic, including price.
• Examples: restaurants, dealer-owned gas stations, Video
rental stores, book & convenience stores, etc.
• Assumptions of the Model:
» Large number of firms
» Differentiated Product
» Conditions of Cost and Demand are Similar
» Easy Entry & Exit
Slide 33
Basic Model of
Monopolistic Competition
MC
• In the Short Run
» produce where MR= MC
» price on the demand curve
• NOTICE:
PM
AC
» P > MC
» economic profits exist
P > AC
» there exists incentives for
entry into this industry
SHORT RUN DIAGRAM
D
QM
MR
Slide 34
Profits in the SR Induces Entry
• Entry in this industry “steals”
customers.
• Demand curve shifts inward
• RESULTS
» MR = MC (like monopoly)
P
» P = AC (like competition)
» Profits in LR are zero (like
competition)
» not at Least Cost Point of AC curve
(like monopoly)
MC
AC
D
D’
Q
MR
LONG RUN DIAGRAM
Slide 35
Monopolistic Competition: Short-Run Equilibrium
-The best level of output = 6 units at point E, where MR=MC
-At Q=6, P=$9 (point A on the D curve) and ATC=$7 (point F) – monopolistic competition earns a
profit of AF=$2 per unit; AFBC=$12 in total (the shaded area)
Slide 36
Monopolistic Competition: Long-Run Equilibrium
Profit 0
The best level of output of monopolistically competitive firm in long run – 4 units at point E’
At MR’=LMC=SMC’ and P=LAC=SATC’=$6 (point A’) – the firm breaks even
Compares to the best level of output of 7 units given by point E”, at MR’=LMC and P=LAC=$5
(point E”) under long run perfectly competitive market equilibrium
Slide 37
Properties of Monopolistic Competition
• Inefficient Production
» EXCESS CAPACITY
• not at least cost point of AC curve
» Could Avoid Excess Capacity by JOINTLY
PRODUCING at the same plant
Slide 38
Selling and Promotional Expenses
• Suppose that the price is determined outside of the model, as with
liquor prices in some States.
• We will expand promotional activities until the extra profit
associated with the activity equals the extra cost of the promotion.
• This decision rule for Optimal Advertising is when:
Contribution Margin = Marginal Cost of Advertising
or
P – MC = k • DA/DQ
or expand advertising whenever (P – MC)( DQ/DA) > k
• where, contribution (P – MC) is the marginal profit contribution
of an additional sale, and the marginal cost of advertising is
( k • DA/DQ).
Slide 39
Example: Radio Advertising
• To sell one more unit of output will cost the price of the
added message, k, divided by the marginal product of
a dollar of advertising (DQ/DA).
• If a radio message costs $1000, and if that message
yields 5 new items sold, then the marginal cost of
advertising is $200, ($1000 /marginal product of
advertising).
• If it costs $200 to sell one more car (MCA=$200), and
if the contribution of another car sold is $300 to profits,
then we should expand promotional expenses.
Slide 40
Competitive Markets Under Asymmetric Information
• Used car: who knows what about it? The
buyer or the seller?
• Asymmetric Information -- unequal or
dissimilar knowledge among market
participants.
• Incomplete Information -- uncertain
knowledge of payoffs, choices, or types of
opponents a market player faces.
Slide 41
Search Goods versus Experience Goods
• Search goods are products or services whose quality is
best detected through a market search.
• Experience goods are products and services whose
quality is undetected when purchased.
• Warranties and firm reputations are used to assure quality.
• But if someone is selling his or her car, isn't it likely that
the car is no good? Is it a lemon?
» This is an explanation why used car prices are
so much lower than new car prices.
• If one firm defrauds customers, how do the reputable firms
signal that they are NOT like the fraudulent firm?
Slide 42
Adverse Selection
and the Notorious Firm
• Suppose that a firm may decide to produce
a High Quality or Low Quality product,
and the buyer may decide to offer a High
Price or a Low Price.
• Since the firm fears that if it offers a High Quality
product but that buyers only offer a Low Price,
they only produce Low Quality products and
receive Low Prices.
• This is the problem of adverse selection
Slide 43
Notorious Firm Analysis
Payoffs in the boxes
are for the seller only
• Simultaneous decisions
BUYER
of buyer & seller
Hi Price Low Price
• A risk averse decision
High
by the firm is to make a
70
Quality 130
Low Quality product SELLER
• Best for the buyer is a
Low
150
90
Quality
low price, but a high
quality good. Worst for
We end in a trap of only
the buyer is a high price
poor quality goods at
but a low quality good.
low prices.
Slide 44
Solutions to the Problem of
Adverse Selection
• Regulation (Disclosure Laws, Truth in Lending)
• Long term relationships, or reliance
relationships
• Brand names (a form of a “hostage” to quality)
• Nonredeployable assets are assets that have
little value in another other use
Example: Dixie Cups made with paper-cup machinery
which cannot be used for other purposes — if Dixie Cups
leak, the company is in trouble
Slide 45
Credible Commitments
•
A credible commitment is a conditional
strategy for establishing trust by promising to
make the promise-giver worse off by violating
that trust
»
such as a promise of product replacement if the product
ever fails.
Examples:
1.
2.
3.
Donney & Bourke promise replacement of handbags
Other firms have sometime promised: If any of my products
fail to work, I will pay the buyer three-times their purchase
price in recompense! Clearly, this commitment makes the firm
worse off if they sell shoddy goods.
Brand names are a “bond” or “hostage” lost if products fail to
live up to promises.
Slide 46
Mechanisms for commitments
• Use of nonredeployable assets such as
reputation. Once lost, a good reputation is hard to
rebuild.
• Entering into alliance relationships which
would fall apart if any party violated their
commitments.
• using a "hostage mechanism" that is
irreversible and irrevocable can deter breaking
commitments.
» Examples are "double your money back
guarantees," and "most favored nation" clauses.
Slide 47