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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?