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Competition First, the Economist’s View Market Structure Continuum Monopolistic Competition Perfect Competition Kinked Demand Oligopoly Monopoly Many Buyers Many Sellers Few Sellers One Seller Small Sellers Homogeneou s Product Large Sellers Large Seller Unique Product Some Differentiation Some Barriers Free Entry & Exit Strong Barriers Perfect Information Price Taker Price Searcher Impersonal Competition LR Π = 0 Personal Competition My Market LR Π > 0 Perfect Competition 1.Many Small Buyers • 2.Many Small Sellers • 3.Homogeneous product • RESULT No market power on the buying side Many alternative vendors No product loyalty (very elastic) EXTREMELY ELASTIC DEMAND Price Taker (takes price as given) 4.No Barriers to Entry • Profits will induce entry • Losses will induce exit • Zero economic profit in Long Run 5.Perfect Information • No mis-steaks (oops, no mistakes) IMPLICATION: Firm & Market have different elasticities. Separate Firm and Market graphs needed Firm • Firm (assumed to be one plant for simplicity) • Cost curves • Profit maximizes at Q where – Marginal Revenue = Marginal Cost • Given Price (assumed fixed), sets Quantity • Determines profit and whether to produce Industry • Collection of individual buyers determine Demand • Collection of firm decisions determines Supply • Equilibrium price set where Quantity demanded = Quantity Supplied • Total Equilibrium Quantity set • For Competition, Firm assumes market results as given • Need – One graph for industry (to set market price) and – One graph for firm (to set quantity for typical firm) The Role of Price • Rationing – – chase low-valued-use customers away – Allocate (scarce) resources to “best” use • Allocation – Move resources from surplus markets to shortage markets • Result: The Invisible Hand Independent Individual Actions in Response to Incentives – Resources used where most valuable – By those valuing the use the most Market and Firm : Competitive Industry/Market Long Run Equilibrium Market Firm P P S MC P1 ATC P=Dfirm=MRfirm AFC TFC D Q1 AVC TVC Q Q1 firm Qfirm Competitive Firm with profit P MC P=Dfirm=MRfirm ATC AVC π TFC TVC Qfirm Q MC = P => Qfirm Profit (Π) = (P-ATC) x Q Creates incentive for entry of new firms Competitive Firm with a Loss P MC ATC AVC Π(negative) P=Dfirm=MRfirm TFC TVC Contribution to Overhead Qfirm Q MC = P => Qfirm Profit (Π) = (P-ATC) x Q < 0 Creates incentive for exit of new firms Competitive Market and Firm: Effect of a Demand Increase Market Firm P P S1 S2 P2 MC ATC P1=Dfirm=MRfirm π TFC P1 D1 Q1 D increase Q2 Q3 Q D2 P2=D=MR TVC Q1 firm Qfirm MC = P2 => Qfirm rises Q2 firm Industry P and Q increase Profit (Π) = (P-ATC) x Q rises Firm’s Demand (P) Rises Creates incentive for entry of new firms Entry occurs until Long Run is re-attained. Π=0 Competitive Market and Firm: Effect of a Demand Decrease Market Firm P S2 P S1 P1 MC ATC P=Dfirm=MRfirm Π(negative) TFC P2 D1 TVC D2 Q3 Q2 Q 1 D decrease Industry P and Q decrease Firm’s Demand (P) Falls P2 Q Q2 firm Q1 firm MC = P2 => Qfirm falls Profit (Π) = (P-ATC) x Q falls (< 0) Creates incentive for exit of firms Qfirm Market Adjustments • Short Run – Industry price adjusted to get Qs = QD – Firms raise or lower Q to equalize MC = P – Profits or Losses are earned • Long run – Firms respond to Profits (enter) or losses (exit) – Price adjusts to change in supply – Firms adjust to new price – Eventually π = 0 and entry or exit stops Competition Implications • Long Run Profits are zero – Due to entry and exit • Maximum surplus (producer + consumer) • Price serves as signal for resource allocation • Presumed when “invisible hand” invoked • May not give “best” distribution or output – Public goods, externalities, equity Inter-industry Adjustments • Profits draw firms into industries decreasing profits for firms already in industry • Losses drive firms out increasing profits for those remaining • Relative profitability may attract firms from one industry to another – Toys-r-us (according to Jay Leno) says it may sell its toy business (??) • Risk differences (etc.) may leave some differences in profitability across industry Efficiency (Presumes Competitive Market) Efficiency • Cannot help one without hurting another – If Marginal benefit > Marginal cost, • increase output – If Marginal benefit < Marginal cost, • decrease output – Efficiency<=>Marginal Benefit=Marginal Cost • In markets happens at D,S intersection • Efficiency is most output, given input • Equity is “fairness” Why and How Efficiency? • Why? – Maximum surplus – Buyers and Sellers satisfied • Why is market equilibrium best? • The following affect output => efficiency down – – – – – Price ceilings Price floors Taxes and Subsidies Monopoly External benefits and costs (effects on others: e.g., pollution) • Price vs non-price allocation Efficiency, graphically Consumer Surplus Benefit for which the consumer does not pay. P S P1 Producer Surplus Revenue without associated opportunity cost. D Q1 Q Effect of a Tax on Efficiency S + tax Consumer Surplus P S Tax P2+tx Tax Revenue P1 P2 Producer Surplus Deadweight Loss Q1 Notice price consumer pays goes up (P1 to P2 + tax) Notice price supplier receives goes down (P1 to P2) D Q2 This is called dead weight loss because these (not produced) units are more valuable than their cost. That is, lost benefit without saved cost. Q Monopoly The Firm as Market Monopoly 1. Many Small Buyers • 2. One Seller • 3. “Unique” product • RESULT No market power on the buying side No alternative vendors No close substitutes LESS ELASTIC DEMAND Price Setter (must choose price) 4. Barriers to Entry • Profits will not induce entry • Losses will not induce exit 5. Perfect Information • No mis-steaks (oops, no mistakes) IMPLICATION: FIRM IS MARKET (one graph) Monopoly decision process • Profit maximization – Marginal Cost = Marginal Revenue – Recognize effect of price on quantity demanded – MC = MR < P (society’s value of product) • Sources of Monopoly Power – – – – Control of resources Government intervention Economies of Scale Network economies (first mover, setting the standard) Decision Process • How Much? – MC = MR => Q* – Given Q*: • • • • P set on demand curve at Q* Ave. Total Cost determined from ATC at Q* Ave. Var. Cost determined from AVC at Q* Ave. Fixed Cost = ATC – AVC at Q* • Whether? – If Price > Ave. Var. Cost at Q*, net cash flow + • So produce—better off producing than not Marginal Revenue for Monopoly • MR = ΔTR/ΔQ Price =revenue change per unit added 30 Revenue at higher price (-) Revenue at lower price 20 Revenue received at either price (+) MR 20 40 D Quantity Net change in revenue is blue box minus yellow ΔTR= P x ΔQ (+) + Q x ΔP (-) MR = {20 x (40-20) + 20 x (20-30)}/(40-20) = 10<20 = {40 x 20 – 30 x 20}/20 = 10 Profit Maximization for Monopolistic firm Monopoly Contribution Margin Qfirm based on MR = MC P P1 => max, given Qfirm TR = P1 x Qfirm Notice: Q set using only marginals MC P1 ATC1 π ATC AVC TFC AVC1 ATC1, given Qfirm TR TVC MR D AVC1, given Qfirm TVC = AVC1 x Qfirm TFC = (ATC1 - AVC1) x Qfirm Qfirm Q π (profit)= (P1 – ATC1) x Qfirm Because of barriers to entry, these profits can persist. Monopoly with a Profit P TC=TFC+TVC TR = P x Q Π = TR – TC = TR – TVC - TFC MC P1 ATC π ATC1 AVC TFC TVC MR Qfirm D Q Monopoly with a Loss P Still wanting to Produce Π<0 MC ATC ATC1 P1 AVC TFC Contribution to overhead. TVC MR Qfirm D Q Monopoly with a Loss P Wanting to Shut Down MC ATC1 Π<0 ATC AVC TFC AVC1 Negative Contribution to overhead. P1 TVC MR Qfirm D Q Effect of Monopoly on Efficiency Monopoly Qfirm based on MR = MC P MC P1 P1 => max, given Qfirm Notice: P and Q set using only marginals P1 is value of last unit sold MC @ Qfirm is the cost of the last unit sold. MR D P>MC @ Qfirm so society loses this surplus As long as P>MC, surplus exists Lost surplus is the triangle Qfirm Q Dead Weight Loss Notice that Setting P=MC (competitive result) will cause no lost surplus Natural Monopoly πMon The key issue is the size of the firm relative to the market. P LMC PMon Preg ATC1 πReg Economies of Scale are significant LAC Demand is such that only one firm has room to be profitable. MR Qfirm QReg D Q Profits would occur without regulation Profits would attract entry => both firms would lose money Rate regulations gives exclusive right to one firm, keeps price down, Increases Q, & assures π Price Discrimination • Separable Markets – Otherwise, people will buy in one market and well in the other. • Different Elasticities – Otherwise, there is no advantage to price discrimination • Raise price in inelastic (P insensitive) market • Lower price in elastic (P sensitive) market • Until MR is the same in each Price Discrimination: Movies Adults Kids P P Lower maximum price Kids are distinguishable PAdults Demand more elastic PKids MC D MR QAdults MR Q D QKids Q Construct MR (MR <P) for each segment in same way as monopoly Assume constant Marginal Cost for simplicity. Find Qfirm as we always do => MC = MR for each section of market Set Price based upon Qfirm and the relevant demand curves. Notice: PAdults > PKids because adult Demand less elastic Competition The Practical Aspects Competition Basics • • • • • Know your competitors (knowledge) Selectively communicate Preannounce price increases SHOW willingness to defend Educate competitors (not worth price war) When to Compete • • • • Cost competitive advantage Niche (claim the whole niche) Complementary products VERY Elastic market To React or not to React • Think Long Term • Is there a better response than price? – If not: • • • • Focus on @ risk customers Focus on incremental value Focus on competitor’s high margin area Raise cost to competitor (educate his/her cust.) – Second round? – Is it worth it? – Mk Share worth Saving?