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Pricing in Various Market Structures
By Gavin C Reid
Professor of Economics, School of Economics & Finance, University of St
Andrews
Director, Centre for Research into Industry, Enterprise, Finance and the Firm
(CRIEFF)
Presentation to the Competition Appeal
Tribunal, London, 6 June 2013
Outline
Basic models
Standards by which to judge economic efficiency
Collusive and non-collusive oligopoly
Two models of oligopoly: partial monopoly/price
leadership; kinked demand curve.
Modern developments: Kinked demand curves
and Edgeworth cycles
Basic Models
• Perfect competition [see Knight (1921),
Makowsky and Ostroy (2001)] - large numbers of
rivals, unimpeded entry and exit, with a
homogenous product, and given technologies.
• Monopoly, Marshall (1890), – sole production of
a homogeneous product, with a fully balkanised
market.
• Oligopoly – ‘competition among the few’, Fellner
(1949), in which each firm is in significant
strategic interaction, and rivalry is limited.
Anti-competitive agreements
Examples of agreements which can be anti-competitive
include, according to Gov.UK, the following:
• price-fixing (agreeing with any other business on a
minimum price at which to sell goods or services)
• limiting production to drive up prices
• if 2 contracts are put out to tender, agreeing with your
competitor to only bid on 1 each
• agreeing not to sell to a competitor’s customers or
compete against them in a certain area
• If 2 or more competitors make agreements like these, it
might constitute a ‘cartel’.
Perfect Competition
Provides a yardstick against which to judge other
forms of competition
Is in itself a fundamental component of the
economist’s analysis of efficiency
Efficiency so conceived is thought of in terms of
Pareto (i.e. a Pareto efficient change makes at least
one economic agent better off without making any
one worse off)
One element of Pareto efficiency, as applied to the
firm, is that price is set equal to marginal cost.
Degree of Monopoly
A commonly adopted measure of degree of
monopoly it the Lerner (1934) index:
L = (Price – Marginal cost)/ Price; or L=(P-MC)/P
It is zero if marginal cost pricing is used i.e. P =
MC
Measuring Monopoly Distortion
Consumers’ and Producers’ Surplus are common
devices for calibrating the efficiency losses due
to monopolisation.
A perfectly competitive market maximizes the
sum of consumers’ and producers’ surplus.
Monopolisation gives rise to a measurable
‘deadweight loss’ of consumers’ and producers’
surplus.
Variants of Basic Models
Monopolistic Competition (Chamberlin, Robinson, 1933) many rivals, mild product differentiation, easy entry and
exit, social optimality or sub-optimality?
Monopoly – partial, Nichol (1930), multiple plant, price
discriminating, natural [e.g. Marshall (1890), Panzar and
Rosse (1987)]
Oligopoly (homogeneous, heterogeneous), collusive, noncollusive [e.g. Cournot (1838), Bertrand (1883)]
Collusive Oligopoly
Cartels – wide variety of forms, including:
• joint profit maximization
• market sharing (e.g. non-price competition,
market quotas)
• price leadership (e.g. low cost, dominant firm,
barometric firm)
• partial monopoly [e.g. Forchheimer (1908), Reid
(1977)]
• basing point
K-firm Cartel Equilibrium
£ per unit
£ per unit
S
MCk
P*
~
R
D
MR
O
xk
x
p* set by cartel (dominant firm, price leader)
p* accepted by fringe
O
xf
xf + xk
x
Non-Collusive Oligopoly
Non-collusive oligopoly analysis includes:
Cournot (1838), Edgeworth, Bertrand (1883),
Stackelberg (1952) leader-follower, Chamberlin
(1933) small group, Hall-Hitch-Sweezy (1939)
kinked demand curve, Maskin and Tirole (1988)
Kinked Demand Curve
• This is a flexible model of heterogenous oligopoly
that seems to capture many aspects of real life
oligopolies.
• There is a kink in the demand curve at the
prevailing price, and above this kink the demand
curve is highly elastic, and below it less elastic.
• The equilibrium price is stable under both cost
and demand variation.
• The pricing behaviour is often consistent with
high price-cost margins.
Kinked demand and Edgeworth cycles
Maskin and Tirole (1988) provide a gametheoretic account of both the kinked demand
curve, and the Edgeworth cycle. They find:
• Firms alternately choose their price
• A special equilibrium type (MPE) which
depends only on the rival’s price
• Show that a kinked demand curve at the
monopoly price is ‘renegotiation proof’
Edgeworth Cycle
• A war of attrition occurs, in which each firm
waits for its rival to increase its price (a
relenting strategy)
• Relenting is a ‘public good’, but each firm
wants its rival to increase the price, so they
can undercut it.
• A mixed strategy emerges with each firm
relenting with a probability less than one, to
avoid free-riding
Conclusion
• Common movement of prices across rivals
(either up or down) is no necessary indication
of collusion, price fixing, inefficiency or
welfare loss: you need to know something
about the market structure.
• Judgment must be exercised as to whether
pricing is collusive.
General References
Hal R Varian (2010) Intermediate
microeconomics: a modern approach (2010), 8th
edition, Prentice Hall.
Oz Shy (1996) Industrial Organization: theory
and applications, MIT Press, (especially Ch. 8).
Geoffrey A. Jehle and Philip J. Reny (2011)
Advanced Microeconomic Theory, 3rd Edition,
Prentice Hall (2011).
Specialised References
Makowsky, L. and J. L. Ostroy (2001),
Perfect competition and the creativity of the
market, Journal of Economic Literature, 39, 479535.
Maskin, E. and J. Tirole (1988) A theory of dynamic
oligopoly II: price competition, kinked demand
curves, and Edgeworth cycles, Econometrica, 56(3),
571-599.
Noel, M. (2007) Edgeworth price cycles, cost-based
pricing and sticky pricing in gasoline retail markets,
Review of Economics and Statistics, 89, 324-334.
Further References
Bhaskar, V., S.Machin and G.C. Reid (1991)
Testing a model of the kinked demand curve,
Journal of Industrial Economics, 34, 241-254.
Reid, G. C. (1977), Comparative statics of the
partial monopoly model, Scottish Journal of
Political Economy, 24(2), 153-162.
Reid, G.C. (1981), The Kinked Demand curve
Analysis of Oligopoly: theory and evidence,
Edinburgh University Press.