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Energy Economics and Policy Spring 2012 Instructors: Chu Xiaodong , Zhang Wen Email:[email protected], [email protected] Office Tel.: 81696127 10 Pure Monopoly McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Four Market Models Characteristics of the Four Basic Market Models Characteristic Pure Competition Monopolistic Competition Oligopoly Monopoly Number of firms A very large number Many Few One Type of product Standardized Differentiated Standardized or differentiated Unique; no close subs. Control over price None Some, but within rather narrow limits Limited by mutual inter-dependence; considerable with collusion Considerable Conditions of entry Very easy, no obstacles Relatively easy Significant obstacles Blocked Nonprice competition None Considerable emphasis on advertising, brand names, trademarks Typically a great deal, particularly with product differentiation Mostly public relation advertising Examples Agriculture Retail trade, dresses, shoes Steel, auto, farm implements Local utilities LO1 10-3 An Introduction to Pure Monopoly • • • • • Single seller – a sole producer No close substitutes – unique product Price maker – control over price Blocked entry – strong barriers to entry block potential competition Non-price competition – mostly PR or advertising the product Public utility companies • Natural Gas • Electric • Water LO1 Near monopolies • Intel • Wham-O Professional sports teams 10-4 Barriers to Entry • Barrier to entry: a factor that keeps firms from entering an industry • Economies of scale • Legal barriers: patents and licenses • Ownership of essential resources • Pricing LO1 10-5 Monopoly Demand • The pure monopolist is the industry • Demand curve is the market demand • LO1 curve • Downsloping demand curve Marginal revenue is less than price 10-6 Monopoly Demand • Marginal revenue < price • Monopolist is a price maker • Monopolist sets prices in elastic region of demand curve LO2 10-7 Output and Price Determination Steps for Graphically Determining the Profit-Maximizing Output, ProfitMaximizing Price, and Economic Profits (if Any) in Pure Monopoly Step 1 Determine the profit-maximizing output by finding where MR=MC. Step 2 Determine the profit-maximizing price by extending a vertical line upward from the output determined in step 1 to the pure monopolist’s demand curve. Step 3 Determine the pure monopolist’s economic profit by using one of two methods: Method 1. Find profit per unit by subtracting the average total cost of the profit-maximizing output from the profit-maximizing price. Then multiply the difference by the profit-maximizing output to determine economic profit (if any). Method 2. Find total cost by multiplying the average total cost of the profit-maximizing output by that output. Find total revenue by multiplying the profit-maximizing output by the profit-maximizing price. Then subtract total cost from total revenue to determine the economic profit (if any). LO2 10-8 Output and Price Determination $200 Price, Costs, and Revenue 175 Pm=$122 MC 150 125 100 75 Economic Profit ATC D A=$94 MR=MC 50 25 0 LO2 MR 1 2 3 4 5 6 Quantity 7 8 9 10 10-9 Misconceptions of Monopoly Pricing • Not highest price • Total profit • Possibility of losses LO2 10-10 Misconceptions of Monopoly Pricing Price, Costs, and Revenue MC A Pm ATC Loss AVC V D MR=MC MR 0 Qm Quantity LO2 10-11 Economic Effects of Monopoly Pure competition is efficient Monopoly is inefficient S=MC MC P=MC= Minimum ATC Pc D Qc (a) Purely Competitive Market LO3 Pm Pc b d c a MR D Qm Qc (b) Pure Monopoly 10-12 Economic Effects of Monopoly • Income transfer • Cost complications • Economies of scale • X-Inefficiency • Rent seeking expenditures • Technological advance LO3 10-13 X-Inefficiency X Average total costs ATCx ATC1 X' ATCx' ATC2 0 LO3 Average Total Cost Q1 Quantity Q2 10-14 Price Discrimination • Price discrimination Price Discrimination • Charging different buyers different prices • Price differences are not based on cost differences • Examples: business travel, electric utilities, movie theaters, golf courses, railroad companies, coupons, international trade LO4 10-15 Price Discrimination • Conditions for success: • Monopoly power • Market segregation • No resale LO4 10-16 Regulated Monopoly • Natural monopolies • Socially optimal price • Set price = marginal cost • Fair return price • Set price = ATC LO5 10-17 Regulated Monopoly Price and Costs (Dollars) Monopoly Price Pm Pf Fair-Return Price a f Pr LO5 ATC r MR 0 Socially Optimal Price Qm MC D b Qf Quantity Qr 10-18 11 Monopolistic Competition and Oligopoly McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Four Market Models Characteristics of the Four Basic Market Models Characteristic Pure Competition Monopolistic Competition Oligopoly Monopoly Number of firms A very large number Many Few One Type of product Standardized Differentiated Standardized or differentiated Unique; no close subs. Control over price None Some, but within rather narrow limits Limited by mutual inter-dependence; considerable with collusion Considerable Conditions of entry Very easy, no obstacles Relatively easy Significant obstacles Blocked Nonprice competition None Considerable emphasis on advertising, brand names, trademarks Typically a great deal, particularly with product differentiation Mostly public relation advertising Examples Agriculture Retail trade, dresses, shoes Steel, auto, farm implements Local utilities LO1 11-20 Monopolistic Competition • Relatively large number of sellers • Differentiated products • Easy entry and exit • Advertising LO1 11-21 Monopolistically Competitive • Industry concentration • Measured by: • Four-firm concentration ratios • Percentage of 4 largest firms 4-Firm CR = Output of four largest firms Total output in the industry • Herfindahl index • Sum of squared market shares HI = (%S1)2 + (%S2)2 + (%S3)2 + …. + (%Sn)2 LO1 11-22 Price and Output in Monopolistic Comp • Demand is highly elastic • Short run profit or loss • Produce where MR=MC • Long run normal profit • Entry and exit • Inefficient • Product variety LO2 11-23 The Short Run: Profit or Loss Price and Costs MC ATC P1 A1 Economic Profit D1 MR = MC MR 0 Q1 Quantity LO2 11-24 The Short Run: Profit or Loss Price and Costs MC ATC A2 P2 Loss D2 MR = MC MR 0 Q2 Quantity LO2 11-25 The Long Run: Only a Normal Profit MC ATC Price and Costs P3 = A 3 D3 MR = MC MR 0 Q3 Quantity LO2 11-26 Monopolistic Competition: Efficiency • Inefficient • Productive inefficiency • P > ATC • Allocative inefficiency • P > MC LO2 11-27 Monopolistic Competition: Efficiency P=MC=Min ATC for pure competition (recall) MC Price and Costs ATC P3 = A 3 P4 Price is Lower D3 MR = MC Excess Capacity at Minimum ATC 0 Q3 MR Q4 Quantity Monopolistic competition is not efficient LO2 11-28 Product Variety • The firm constantly manages price, • LO2 product, and advertising • Better product differentiation • Better advertising The consumer benefits by greater array of choices and better products • Types and styles • Brands and quality 11-29 Oligopoly • A few large producers • Homogeneous or differentiated products • Limited control over price • Mutual interdependence • Strategic behavior • Entry barriers • Mergers LO3 11-30 Oligopolistic Industries • Four-firm concentration ratio • 40% or more to be oligopoly • Shortcomings • Localized markets • Inter-industry competition • World price • Dominant firms LO3 11-31 Game Theory Overview • Oligopolies display strategic pricing behavior • Mutual interdependence • Collusion • Incentive to cheat • Prisoner’s dilemma LO4 11-32 Game Theory Overview RareAir’s Price Strategy LO4 High A Uptown’s Price Strategy •2 competitors •2 price strategies •Each strategy has a payoff matrix •Greatest combined profit •Independent actions stimulate a response $12 Low B $15 High $12 C $6 $6 D $8 Low $15 $8 11-33 Game Theory Overview RareAir’s Price Strategy LO4 High A Uptown’s Price Strategy •Independently lowered prices in expectation of greater profit leads to worst combined outcome •Eventually low outcomes make firms return to higher prices. $12 Low B $15 High $12 C $6 $6 D $8 Low $15 $8 11-34 Three Oligopoly Models • Kinked-demand curve • Collusive pricing • Price leadership • Reasons for 3 models • Diversity of oligopolies • Complications of interdependence LO5 11-35 Kinked-Demand Curve Rivals Ignore Price Increase MC1 e P0 f Rivals Match Price Decrease 0 P0 MR2 e f MC2 MR2 g g D1 Q0 Quantity LO5 D2 Price Price D2 MR1 D1 0 Q0 MR1 Quantity 11-36 Kinked-Demand Curve • Criticisms • Explains inflexibility, not price • Prices are not that rigid • Price wars LO6 11-37 Cartels and Other Collusion Price and Costs MC P0 ATC A0 MR=MC Economic Profit Q0 LO6 D MR Quantity 11-38 Overt Collusion • Cartels - a group of firms or nations that • • LO6 collude • Formally agreeing to the price • Sets output levels for members Collusion is illegal in the United States OPEC 11-39 Obstacles to Collusion • Demand and cost differences • Number of firms • Cheating • Recession • New entrants • Legal obstacles LO6 11-40 Price Leadership Model • Price Leadership • Dominant firm initiates price changes • Other firms follow the leader • Use limit pricing to block entry of new • LO6 firms Possible price war 11-41 Oligopoly and Advertising • Prevalent to compete with product development and advertising • Less easily duplicated than a price change • Financially able to advertise LO7 11-42 Advertising Positive Effects Negative Effects Low-cost way of providing information to consumers Can be manipulative Enhances competition Contains misleading claims that confuse consumers Speeds up technological progress Consumers pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product Can help firms obtain economies of scale LO7 11-43 Oligopoly and Efficiency • Oligopolies are inefficient • Productively inefficient P > minATC • Allocatively inefficient P > MC • Qualifications • Increased foreign competition • Limit pricing • Technological advance LO7 11-44 Next Lecture • The main topic will be Coal Markets and Oil Markets • Pages from textbooks are good learning reference including Chapters 18 and 19 of [Evans & Hunt, 2009]