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Topic 7: Market Structures Agenda, Friday 26th November 2010 A: Supply and Perfect Competition B: Monopoly C: Perfect Competition v. Monopoly D: Oligopoly and Game Theory A: Supply and Perfect Competition Firm Supply How does a firm decide how much to supply at a particular market price? (Firm’s supply curve) This depends upon the firm’s – goals (e.g. π max, revenue max, zero π, … ); – technology (e.g. w, r, … ); – competitive environment/market structure. Perfect Competition Assumptions There are many buyers and sellers, – each seller is (or at least acts as) a price-taker Homogeneous product Freedom of entry and exit Perfect information (consumers know all prices and producers know all input prices/costs) The Firm’s Short-Run Supply Decision? Assume each firm is a profitmaximizer Therefore, each firm chooses its output level by solving: MR = MC But MR = P in perfect competition Therefore P = MC The Firm’s Short-Run Supply Decision? P pe MCs(y) y’ ys* At y = ys*, p = MC and MC slopes upwards, y = ys* is profity maximizing. P The Firm’s Short-Run Supply Decision? pe MCs(y) y’ ys* So a profitmaximizing supply level can lie only on the upwards sloping part of the firm’s y MC curve. The Firm’s Short-Run Supply Decision? The firm will not supply any output if p AVC ( y ) Shut Down Point: P = AVC(y) The Firm’s Short-Run Supply Decision? P Shutdown MC (y) s point ACs(y) AVCs(y) The firm’s short-run supply curve y Short Run Market Supply Curve P S Market Supply Curve is the sum of all the firms supply curves (MC) Q Perfect Competition: Equilibrium Short run: (Excess, Abnormal, Supernormal, Economic) Profits or Losses (≤ TVC) possible Short run → Long run: Profits attracts entry, market supply curve shifts to right, market price falls, zero economic profits in long run equilibrium Short run → Long run: Losses “attracts” exit, … Application: Tax Incidence In Perfect Competition Market Supply P PC = PP Market Demand Q No tax: PC = PP (Consumer price = Producer price) Application: Tax Incidence In Perfect Competition P Market Supply PC This is the tax. PP Market Demand Q The tax creates a wedge between the price firms receive (Pp) and the price consumers pay (Pc). The difference is the tax (which goes to the tax authorities). Application: Tax Incidence In Perfect Competition P Market Supply PC This is the tax PP Market Demand Q In the short run, the burden of the tax is shared (not necessarily on a 50/50 basis) between consumers and producers. Application: Tax Incidence In Perfect Competition In the short run, The producers receives less for the product. Some firms will continue to produce output at a loss (once the reduced price is covering their average variable costs). Some firms will experience “excessive” losses and so will exit the market. The supply curve shifts to the left and the prices consumers and producers face increases. Application: Tax Incidence In Perfect Competition In the Long Run, Consumers pay all of the tax (100%) Producers pay none of tax (0%) There are no firms making losses left in the market. B: Monopoly Monopoly: Why? Natural monopoly (economies of scale or density) - utility companies, e.g. electricity or natural gas or cable or rail (transmission) network, household waste collection Statutory monopoly – a patent; e.g. a new drug – sole ownership of a resource; e.g. a toll bridge Artificial monopoly, e.g. explicit formation of a cartel, e.g. OPEC Monopoly: Assumptions Many buyers Only one seller i.e. not a price-taker (Homogeneous product) Perfect information Restricted entry (and possibly restricted exit) Monopoly: Market Behaviour p(y) Higher output y causes a lower market price, p(y). D y=Q Monopoly: Equilibrium P Demand MR y=q=Q Monopoly: Equilibrium MC P AC MR Demand y Monopoly: Equilibrium MC P Output Decision AC ym MR Demand MC = MR y Monopoly: Equilibrium Pm = price MC P AC Pm ym MR Demand y Monopoly: Equilibrium Firm = Market Short run equilibrium diagram = long run equilibrium diagram (apart from shape of cost curves and possibility of exit) At qm, pm > AC therefore you have excess (economic, supernormal, abnormal) profits Short run losses are also possible Monopoly: Equilibrium MC P AC Pm ym MR The shaded area is the excess profit Demand y Application: Tax Incidence in Monopoly P MC curve is assumed to be constant (for ease of analysis) MC MR Demand y Application: Tax Incidence in Monopoly Claim When you have a linear demand curve, a constant marginal cost curve and a tax is introduced, price to consumers increases by “only” 50% of the tax, i.e. “only” 50% of the tax is passed on to consumers. (Similarly, if tax is eliminated, only 50% of price reduction is passed on to consumers.) Application: Tax Incidence in Monopoly Output decision is as before, i.e. P MC = MR So Ybt is the output before the tax is imposed MCbt ybt MR Demand y Application: Tax Incidence in Monopoly Price is also the same as before P Pbt = price before tax is introduced. Pbt MCbt ybt MR Demand y Application: Tax Incidence in Monopoly The tax causes the MC curve to shift upwards P Pbt MCat MCbt ybt MR Demand y Application: Tax Incidence in Monopoly Price post tax is at Ppt and is higher than before. P Ppt Pbt MCat MCbt yat ybt MR Demand y C: Monopoly v. Perfect Competition Agenda Societal Welfare/Economic Welfare: Criteria? Consumer Surplus Producer Surplus Compare Monopoly and Perfect Competition Economic Welfare Consumer surplus measures (net) economic welfare from the buyer/consumers’ perspective. Producer surplus measures (net) economic welfare from the seller/producers’ perspective. Consumer Surplus Consumer surplus is the amount a buyer is willing to pay for a product minus the amount the buyer actually pays. Consumer surplus is the area below the demand curve and above the market price. A lower market price will increase consumer surplus (provided that the product is still supplied, of course). A higher market price will reduce consumer surplus. Producer Surplus Producer surplus is the amount a seller is paid for a product minus the total variable cost of production. A higher market price will increase producer surplus (provided that the product is still demanded, of course). A lower market price will decrease producer surplus. Producer surplus is equivalent to economic profit in the long run. Economic Welfare Economic welfare is (generally) quantified as the sum of consumer surplus and producer surplus, i.e. equal weights are generally assumed. Alternative relative weights are also possible. Consumer Surplus and Producer Surplus: Market Equilibrium Price A D Supply Consumer surplus Equilibrium price E Producer surplus B Demand C 0 Equilibrium quantity Quantity Monopoly v. Perfect Competition MC Price is Ppc P Ppc Qpc Demand Q Monopoly v. Perfect Competition MC P Recall that for monopoly, MR Demand Output is set where MC = MR Ppc Qm Qpc MR Demand Q Monopoly v. Perfect Competition MC P Pm The monopoly output is less than the perfectly competitive output. (The monopoly price is higher than the perfectly competitive price.) Ppc Qm Qpc MR Demand Q Monopoly v. Perfect Competition MC P Pm The green area represents the deadweight loss (triangle) of Monopoly Ppc Qm Qpc MR Demand Q Economic Efficiency: Monopoly v. Perfect Competition Comment PC v. M P = MC? PC MX Productive Efficiency? Minimum point on AC Curve? PC M X? Excess profit? + Rent seeking? PC MX X-inefficiency? “Excessive” Costs? PC M? Technical progress/innovation? Monopoly excess profits can be reinvested PC ? M? Natural monopoly? Perfect competition impossible PC X M Allocative Efficiency? D: Oligopoly & Game Theory Oligopoly: Assumptions Many buyers Very small number of major sellers ( actions and reactions are very important) Homogeneous product (usually, but not necessarily) Complete information (usually, but not necessarily) Restricted entry (usually, but not necessarily) Oligopoly & Game Theory: Models 1. 2. 3. 4. Cournot Competition (1838) (Bertrand Competition (1883)) Nash Equilibrium (1950s): Game Theory Oligopoly v. Perfect Competition v. Monopoly Some examples of Games 1. Cournot Competition Firms compete in quantities (q1, q2) Real world examples? q1 = F(q2) and q2 = G(q1) or more precisely q1 = F(q2e) and q2 = G(q1e) Aim: Find q1and q2 and hence P, i.e. find the equilibrium. Example: P = a – bQ and Ci = cqi 1. Cournot Competition: Example q2 a c bq2 q1 2b COURNOT EQUILIBRIUM a c bq1 q2 2b q1 2. Cournot Competition & Bertrand Competition: Nash Equilibrium Cournot Nash (q1, q2): Firms compete in quantities, i.e. Firm 1 chooses the best q1 given q2 and Firm 2 chooses the best q2 given q1 [Bertrand Nash (p1, p2): Firms compete in prices, i.e. Firm 1 chooses the best p1 given p2 and Firm 2 chooses the best p2 given p1] Nash Equilibrium (s1*, s2*): Player 1 chooses the best s1 given s2* and Player 2 chooses the best s2 given s1* 3. Perfect Competition v Monopoly v Oligopoly (Cournot) Qm < Qco < QPC Pm > Pco > Ppc 4. Examples of Games: Advertising Game (≈ Prisoners’ Dilemma) Firm j Advertise Don’t Advertise Firm Advertise (i=2,j=2) i (i=4,j=1) Don’t (i=1,j=4) Advertise (i=3,j=3) 4. Advertising Game (≈ Prisoners’ Dilemma) Nash equilibrium = Advertise, Advertise = [2,2] [2,2] < [3,3] i.e. Nash equilibrium can be inefficient! (We are ignoring consumer interests.) Government bans advertising (e.g. for cigarettes or spirits or beer or ban on below cost selling?) 4. Examples of Games: Eating Out Game Person j Chinese Italian Person Chinese (i=4,j=2) (i=1,j=1) i Italian (i=1,j=1) (i=2,j=4) 4. Eating Out Game Nash equilibrium = Chinese, Chinese [4,2] Nash equilibrium = Italian, Italian = [2,4] 3rd Nash equilibrium = ? (It’s there somewhere – I promise.) Multiple equilibria! 4. Examples of Games: Chicken “Game” Person j Swerve Don’t Swerve Person Swerve (i=2,j=2) i (i=1,j=4) Don’t (i=4,j=1) Swerve (i=0,j=0) 4. Chicken “Game” Nash equilibrium = Swerve, Don’t Swerve = [1,4] Nash equilibrium = Don’t Swerve, Swerve = [4,1] 3rd Nash equilibrium = ? Commitment mechanism? 4. Examples of Games: Matching Pennies Game Person j Heads Person Heads i Tails Tails (i=1,j=-1) (i=-1,j=1) (i=-1,j=1) (i=1,j=-1) 4. Matching Pennies Game Nash equilibrium = ? No pure strategy Nash equilibrium Mixed strategy Nash equilibrium = 50%, 50% Scissors, Rock, Paper: Mixed strategy Nash equilibrium = ?