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Understanding Economics 5th edition by Mark Lovewell Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. 5th edition by Mark Lovewell Chapter 6 Monopoly and Imperfect Competition Copyright © 20109 by McGraw-Hill Ryerson Limited. All rights reserved. Learning Objectives After this chapter you will be able to: outline the demand conditions faced by monopolists, monopolistic competitors, and oligopolists 2. distinguish how monopolists, monopolistic competitors, and oligopolists maximize profits 3. understand nonprice competition, and the arguments over industrial concentration 1. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Monopolist’s Demand A monopolist’s demand curve is the same as for the entire market it is downward sloping Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Demand Faced by a Monopolist Figure 6.1, Page 144 Demand Curve for Megacomp Demand Schedule for Megacomp ($ millions per computer) $160 120 80 (computers per year) 1 2 3 a 160 Price ($ millions per computer) Quantity Demanded Price 200 b 120 c 80 D 40 0 1 2 3 4 Quantity (computers per year) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Monopolistic Competitor’s Demand A monopolistic competitor’s demand curve is elastic because of many substitutes for the business’s product Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Demand Faced by a Monopolist Competitor Figure 6.2, Page 145 Demand Curve for Jaded Palate Demand Schedule for Jaded Palate Price ($ per meal) $11 10 9 8 (meals per day) 100 200 300 400 Price ($ per meal) 12 Quantity Demanded 10 8 D 6 4 2 0 100 200 300 400 Quantity (meals per day) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Oligopolist’s Demand Oligopolies are characterized by mutual interdependence. Oligopolists in a market characterized by rivalry face a kinked demand curve. A business raising price finds rivals keep theirs constant, so demand is relatively flat. A business reducing price finds rivals raise theirs as well, so demand is relatively steep. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Actions and Reactions among Rivals in an Oligopoly Figure 6.3, Page 145 Probable Response of Competitors Effect on Company A’s Market Share raise price keep prices constant product now highpriced, so market share falls large increase as market share lost to competitors lower price match price drop since all companies selling at lower price, Company A’s market share stays constant small increase as lower prices for all companies attract new buyers Action of Company A Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Company A’s Quantity Demanded Demand Faced Among Rivals in an Oligopoly Figure 6.4, Page 146 Demand Schedule For Centaur Cars Demand Curve for Centaur Cars Price Quantity Demanded ($ thousands per car) (thousands of cars per year) $35 30 20 10 10 20 25 30 Price ($ thousands per car) 40 30 20 D 10 0 10 20 30 Quantity (thousands of cars per year) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Cooperative Oligopolies There are various ways that oligopolists can cooperate: price leadership collusion cartel Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Revenue Conditions for a Monopolist A monopolist’s average revenue is the same as the downward-sloping market demand curve. A monopolist’s marginal revenue is below its demand curve because demand (average revenue) falls as quantity increases. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Revenues for a Monopolist Figure 6.5, Page 148 Revenue Curves for Megacomp Revenue Schedules for Megacomp Price (P) Quantity (Q) ($ millions per (computers computer) per year) $160 120 80 40 0 1 2 3 4 Total Revenue (TR) (P x Q) Marginal Average Revenue Revenue (MR) (AR) (ΔTR/ΔQ) (TR/Q) ($ millions ($ millions per per ($ millions) computer) computer) $ 0 160 240 240 160 $160 80 0 -80 $160/1 = 240/2 = 240/3 = 160/4 = 160 120 80 40 $ Millions per Computer 200 160 120 80 40 D =AR 0 -40 -80 1 2 3 4 MR Quantity of Computers per Year Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Profit-Maximization for a Monopolist (a) A monopolist maximizes profit at the quantity where marginal revenue and marginal cost are equal. At this output, the monopolist charges the highest possible price, as found using the demand curve. Monopolists meet neither the minimum-cost pricing nor the marginal-cost pricing conditions. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Profit Maximization for a Monopolist (b) Figure 6.6, Page 149 Profit Maximization Table for Megacomp Price (P) (AR) ($ millions per computer) Quantity (Q) (computers per year) 0 1 2 3 4 $160 120 80 40 Total Revenue (TR) (P x Q) ($ millions) Marginal Revenue Marginal Cost Average Cost (AC) (MR) (MC) (ΔTR/ΔQ) ($ millions per ($ millions per ($ millions per computer) computer) computer) $ 0 160 240 240 160 $160 80 0 -80 $ 60 40 70 150 $ Millions per computer Profit Maximization Graph for Megacomp 200 MC 160 120 90 80 b c 40 0 AC Profit = $60 million a 1 D MR 2 Quantity of Computers per Year Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. 3 4 $140 90 83 100 Other Features of Monopolies A monopolist charges a higher price and a lower quantity than would occur if the market were perfectly competitive. Regulators of monopolies usually adopt average-cost pricing in an effort to make regulated monopolies break even. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Monopoly versus Perfect Competition Figure 6.7, Page 150 7 $ per T-Shirt S(=MC) c a 4 b D MR 0 18 000 22 000 Quantity of T-Shirts per Day Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Revenue Conditions for a Monopolistic Competitor A monopolistic competitor’s average revenue is the same as its downward-sloping demand curve. A monopolistic competitor’s marginal revenue is below its demand curve because demand (average revenue) falls as quantity increases. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Revenues for a Monopolistic Competitor Figure 6.8, Page 153 Revenue Schedules for Jaded Palate Price Quantity (P) (Q) ($ meal) (meals per day) $-11 10 9 8 Total Revenue (TR) (P x Q) Marginal Revenue (MR) (ΔTR/ΔQ) $ 0 1100 2000 2700 3200 1100/100 = $11 900/100 = 9 700/100 = 7 500/100 = 5 0 100 200 300 400 Revenue Curves for Jaded Palate 12 $ per Meal 10 8 D = AR 6 MR 4 2 0 100 200 300 400 Quantity of Meals per Year Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Average Revenue (AR) TR/Q) 1100/100 = $11 2000/200 = 10 2700/300 = 9 3200/400 = 8 Profit-Maximization for a Monopolistic Competitor (a) The profit-maximizing quantity for a monopolistic competitor is found where marginal revenue and marginal cost are equal. Price is found with the aid of the business’s demand curve. In the short run a monopolistic competitor may make a profit or a loss at its profit-maximizing point. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Profit-Maximization for a Monopolistic Competitor (b) In the long run, a monopolistic competitor breaks even. If profits (losses) are being made in the short run, new businesses enter (leave) the industry, pushing businesses’ demand curves leftward (rightward) and making them more (less) elastic. The business meets neither the minimum-cost pricing nor the marginal-cost pricing rules, since too few units of output are produced. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Profit Maximization for a Monopolistic Competitor (c) Figure 6.9, Page 154 Short-Run Profit Maximization For Jaded Palate Long-Run Profit Maximization For Jaded Palate MC $ per Meal 8.00 b AC D0 c MR 200 Quantity of Meals per Day e 7.50 a 0 MC minimum point of AC D1 $ per Meal 10.00 d MR 0 150 Quantity of Meals per Day Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. AC Revenue Conditions for an Oligopolist For an oligopolist in a market characterized by rivalry, average revenue is identical with its kinked demand curve. This business’s marginal revenue curve has two linear segments which are below its kinked demand curve Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Profit-Maximization for an Oligopolist (a) The profit-maximizing quantity for this type of oligipolist is found where marginal revenue and marginal cost are equal. Price is found using the business’s kinked demand curve. Oligopolists meet neither the minimum-cost pricing nor the marginal-cost pricing rules. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Profit Maximization for an Oligopolist (b) Figure 6.10, Page 156 Profit Maximization Graph for Centaur Cars Profit Maximization Table for Centaur Cars 40 -$35 30 20 10 Quantity (Q) 0 10 20 25 30 0 350 600 500 300 35 25 -20 -40 15 10 15 25 30 20 19 20 b 30 $ Thousands per car Total Marginal Marginal Average Revenue Revenue Cost Cost (TR) (MR) (MC) (AC) (P x Q) (ΔTR/ΔQ) ($ thousands (thousands ($ ($ ($ of cars per ($ Per car) thousands thousands thousands year) millions) per car) per car) per car) Price (P) (=AR) 20 MC Profit = $200 million c 10 a D 0 -10 10 20 30 -20 -30 -40 MR Quantity (thousands of cars per year) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. AC Game Theory Game theory is the analysis of how mutually interdependent actors try to achieve their goals through the use of strategy. Originally a field in mathematics, game theory has become a set of concepts whose use has spread to all social sciences, especially economics. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The Prisoner’s Dilemma (a) The prisoner’s dilemma is a classic example of how players’ self-interested actions can be self-defeating. It refers to a case in which two arrested men are in separate cells and are facing the choice of whether or not to confess. If both confess, each gets a jail time of 5 years. If one confesses and the other doesn’t, the confessor gets off and the other gets 10 years. If both don’t confess, they each get one year of jail. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The Prisoner’s Dilemma (b) By following a narrowly self-interested strategy that minimizes his own potential harm, each prisoner has an incentive to confess, even though the best possible result would be if both stayed silent. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The Prisoner’s Dilemma Figure 6.11, Page 158 Paul’s Strategies Don’t Confess Confess Don’t Confess Peter’s Strategies Confess Paul: 5 Peter: 5 Paul: 10 Peter: 0 Paul: 0 Peter: 10 Paul: 1 Peter: 1 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Applying the Prisoner’s Dilemma to Oligopoly (a) The prisoner’s dilemma can be applied to oligopoly by looking at two businesses that have entered a collusive agreement to charge a high price. If both businesses live by the agreement, they each make $20 million in profit. If one cheats and the other doesn’t, the cheater makes $25 million in profit and the other makes $10 million. If both cheat, they each make $15 million. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Applying the Prisoner’s Dilemma to Oligopoly (b) If price cutting can be accomplished in an underhanded way, each business has an incentive to cheat, since the profit for the cheater (when the other business is living within the agreement) is higher than otherwise. But if both businesses cheat, each makes a lower profit than they would do if both lived within the agreement. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The Case of Oligopoly Figure 6.12, Page 159 Delta’s Strategies Don’t Cheat Cheat D: $20 m. G: $20 m. D: 25 m. G: $10 m. D: $10 m. Cheat Gamma’s Strategies Don’t Cheat G: $25 m. D: 15 m. G: $15 m. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Anti-Combines Legislation (a) Anti-combines legislation represents laws aimed at preventing industrial concentration and abuses of market power. The Competition Act of 1986 was a major reform of Canada’s anti-combines legislation. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Anti-Combines Legislation (b) Criminal offences under the Competition Act include: conspiracy bid-rigging predatory pricing abuse of dominant position Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Anti-Combines Legislation (c) Civil matters reviewed by the Competition Tribunal include: abuse of dominant position mergers horizontal merger vertical merger conglomerate merger Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Nonprice Competition Nonprice competition by monopolistic competitors and oligopolists includes: product differentiation advertising Nonprice competition raises a business’s revenue and costs. Nonprice competition may or may not be beneficial to businesses and consumers. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Industrial Concentration Industrial concentration refers to market domination by a few large businesses. It can provide the consumer with benefits due to increasing returns to scale. It can impose costs on the consumer due to market power. It may or may not encourage technical innovation. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Concentration Ratios Industrial concentration is measured using concentration ratios. The four-firm concentration ratio shows the percentage of total sales revenue in a market earned by the four largest business firms. Concentration ratios overestimate competition in localized markets and underestimate it in global markets. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Concentration Ratios in Selected Canadian Industries (1988) Figure 6.13, Page 165 Share of Industry Sales by Four Largest Businesses Tobacco products Petroleum and coal products Transportation Beverages Metal mining Paper and allied industries Electrical products Printing, publishing, and allied industries Food Finance Machinery Retail trade Clothing industries Construction Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. 98.9 74.5 68.5 59.2 58.9 38.9 32.1 25.7 19.6 16.4 11.3 9.7 6.6 2.2 Concentration in the Canadian Economy (1999) Figure 6.14, Page 166 Share of Assets and Share of Revenues for Enterprises with $75 million or More in Revenues Assets Foreign Canadian Revenues 18.9 57.8 26.2 30.5 76.7 56.7 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The Games People Play (a) Thomas Schelling applied game theory principles to military strategy, showing how the most effective deterrence during the nuclear arms race between the US and the Soviet Union was not first-strike capability, but second strike capability. He explained this using the example of two gunfighters in a threatened shootout, who would both be loath to shoot “if both were assured of living long enough to shoot back with unimpaired aim.” Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The Games People Play (b) Schelling also showed how, in many ordinary social situations, a divergence between what people are motivated to do individually and what they would like to accomplish collectively creates conditions for breaking the laissez faire principle. One example is the rationing of electricity during summer shortages. In this case, rules-based rationing makes more sense than merely appealing to people’s civic virtue, says Schelling. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The OPEC Cartel (a) (Online Learning Centre) The Organization of Petroleum Exporting Countries is an example of a cartel that has had some success in the past in influencing the global price of oil. During the 1970s, OPEC members used marketsharing agreements to significantly raise this price. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The OPEC Cartel (b) (Online Learning Centre) In the 1980s, the oil price fell and OPEC’s influence waned. This was due to: a reduction in quantity demanded – a delayed reaction to the high prices of the 1970s increases in quantity supplied by non-OPEC producers cheating by some OPEC members, who secretly raised output to counteract reduced prices, and thereby made the price reductions even greater Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The OPEC Cartel (c) (Online Learning Centre) During the 1990s and the early 2000s, despite continuing conflicts within OPEC, oil prices were driven much higher, due to a variety of factors, including political considerations: the Iraq War and its aftermath tensions between the West and Iran Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The Just Price (a) (Online Learning Centre) The medieval philosopher Thomas Aquinas provided a comprehensive world view that included a treatment of economic issues. He argued that lending for interest was unfair to borrowers. According to this view, interest payments bring into question the stability of the monetary system, since they seem to presume that money necessarily depreciates in value. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The Just Price (b) (Online Learning Centre) The condemnation of what was then called usury was virtually impossible to enforce, with interest being hidden by lenders in other payments made by borrowers. Aquinas extended Aristotle’s theory of exchange by refining the notion of a just price. Whereas Aristotle believed that selling for a price higher than one paid was unethical, Aquinas recognized traders deserved a return that covered more than out-of-pocket costs. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. The Just Price (c) (Online Learning Centre) Aquinas’s followers gradually extended the idea of the just price so that it came to be seen as the value of an item that allowed producers to maintain their customary position in society. The notion of the just price is still used today, for example in markets governed by price controls. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved. Chapter 6 The End Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.