Download Unit IV: Imperfect Competition

Unit IV:
Imperfect Competition
Characteristics
of Monopolies
5 Characteristics of a Monopoly
1. Single Seller
• One Firm controls the vast majority of a
market
• The Firm IS the Industry
2. Unique good with no close substitutes
3. “Price Maker”
• The firm can change the price by
changing the quantity it produces (ie.
shifting the supply curve to the left).
5 Characteristics of a Monopoly
4. High Barriers to Entry
• New firms CANNOT enter market
• No immediate competitors
5. Some “Nonprice” Competition
• Despite having no close
competitors, monopolies still
advertise their products in an
effort to increase demand.
Examples of
Monopolies
Four Origins of Monopolies
1. Geographical Monopolies
Ex: Nowhere gas stations, De Beers Diamonds, San Diego
Chargers, Cable TV, Qualcomm Hot Dogs…
-Location or control of resources limits competition
and leads to one supplier.
2. Government Monopolies
Ex: Water Company, Firefighters, The Army,
Pharmaceutical drugs, rubix cubes…
-Government allows monopoly for public benefits or
to stimulate ingenuity.
-The government issues patents to protect inventors
and forbids others from using their invention.
(They last 20 years)
Four Origins of Monopolies
3. Technological Monopolies
Ex: Microsoft, Intel, Frisbee, Band-Aide…
-Patents and widespread availability of certain products
lead to only one major firm controlling a market.
4. Natural Monopolies
Ex: Electric Companies (SDGE)
• If there were three competing electric companies
they would have higher costs.
• Having only one electric company keeps prices low
-Economies of scale make it impractical to have
smaller firms.
-Low average total costs act as a barrier to entry for
other firms.
Average Total Cost
Electric companies have economies of scale. The
more they produce the lower the average cost.
Assume that 200
units need to be
produced
$20
15
LRATC
10
•If there are 4 firms, the ATC is $20
•If there are 2 firms the ATC is $15
•If there is 1 firm the ATC is $10
0
50
100
Quantity
200
Drawing
Monopolies
Good news…
1. Only one graph because the firm
IS the industry.
2. The cost curves are the same
3. The MR= MC rule still applies
4. Shut down rule still applies
• Unlike perfect competition, all
imperfectly competitive firms have
downward sloping demand curve.
• To sell more a firm must lower its price.
Combine the Demand of an industry
with the costs of a firm.
Costs (dollars)
MC
ATC
What about MR?
D
Quantity
To sell more a firm must lower its price. What
happens to Marginal Revenue?
Price
Quantity
Demanded
$6
0
$5
1
$4
2
$3
3
$2
4
$1
5
Total
Revenue
Marginal
Revenue
Does the Marginal Revenue equal the price?
To sell more a firm must lower its price. What
happens to Marginal Revenue?
Price
Quantity
Demanded
Total
Revenue
$6
0
0
$5
1
5
$4
2
8
$3
3
9
$2
4
8
$1
5
5
Marginal
Revenue
Does the Marginal Revenue equal the price?
To sell more a firm must lower its price. What
happens to Marginal Revenue?
Price
Quantity
Demanded
Total
Revenue
Marginal
Revenue
$6
0
0
-
$5
$4
MR
1 DOESN’T
5
2
8
EQUAL PRICE
5
3
$3
3
9
1
$2
4
8
-1
$1
5
5
-3
Plot Demand and Marginal Revenue Curves
Plot Demand and Marginal Revenue Curves
Quantity
0
1
2
3
4
5
6
7
8
9
10
Price
$16
15
14
13
12
11
10
9
8
7
6
TR
0
15
28
39
48
55
60
63
64
63
60
MR
15
13
11
9
7
5
3
1
-1
-3
Plot Demand and Marginal Revenue Curves
Quantity
0
1
2
3
4
5
6
7
8
9
Price
$16
15
14
13
12
11
10
9
8
7
TR
0
15
28
39
48
55
60
63
64
63
MR
15
13
11
9
7
5
3
1
-1
10
6
60
-3
Why is MR below Demand?
P
As price decreases from
$100 to $90...
revenue will
increase with the
additional
unit sold.
$100
90
60 TR=$300
40
D
TR = $360
1
2
3
4
5
6
Q
Why is MR below Demand?
P
But a lower price results in a loss
of the $30 that was earned when
price was $10 higher
$100 Loss =
90 $30
60 TR=$300
40
D
TR = $360
1
2
Gain = $90
3
4
5
6
Q
Why is MR below Demand?
P Marginal Revenue is ADDITIONAL REVENUE
$100
90
MR= (Price –Loss from lowering price)
MR= $90 - $30
= $60
Loss =
$30
60 TR=$300
40
D
TR = $360
1
2
Gain = $90
3
4
5
6
Q
Why is MR below Demand?
P
As price decreases from
$90 to $80 TR increases
MR= $80 – 40 = $40
$100
90
80
Loss= $40
60
D
40
Gain = $80
1
2
3
4
5
6
Q
Why is MR below Demand?
P
$100
90
80
60
D
40
MR
1
2
3
4
5
6
Q
Why is MR below Demand?
P
$100
90 MR
80
CURVE IS LESS
THAN
60 DEMAND CURVE!!!
40
MR
1
2
3
4
5
6
Q
D
Elastic vs. Inelastic
Range of Demand
Curve
Elastic and Inelastic Range
Dollars
$200
150
100
50
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q
Dollars
$750
500
250
Q
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Elastic and Inelastic Range
Elastic
If price falls and
TR increases
then demand is
elastic.
150
100
50
MR
D
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q
$750
Dollars
Total Revenue
Test
Dollars
$200
500
TR
250
Q
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Elastic and Inelastic Range
Elastic
Inelastic
Total Revenue
Test
If price falls and
TR increases
then demand is
elastic.
Dollars
$200
100
50
Total
Revenue Test
MR
D
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q
$750
Dollars
If price falls
and TR falls
then demand is
inelastic.
150
500
250
When MR
goes negative,
TR will fall
TR
Q
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Putting
Demand, MR,
and Cost
Together
What output should this monopoly produce?
MR = MC
How much
is the TR, TC and Profit or Loss?
200
Price, costs, and revenue
175
MC
$9
150
8
125
7 Profit =$5
100
6
ATC
5
4
50
3
D
75
25
MR
2
0
1
2
3
4
5
6
7
8
9
10
Q
Conclusion: A monopolists produces where
MR=MC, buts charges the price consumer are
willing 200
to pay identified by the demand curve.
Price, costs, and revenue
175
MC
$9
150
8
125
7
100
6
ATC
5
4
50
3
D
75
25
MR
2
0
1
2
3
4
5
6
7
8
9
10
Q
What if cost are higher?
How much is the TR, TC, and Profit or Loss?
200
Price, costs, and revenue
175
MC
ATC
150
140
Loss
125
AVC
100
D
75
Minimum AVC is
shut down point
50
25
MR
0
1
2
3
4
5
Q
6
7
8
9
10
Q
Identify and
200
TR=
Calculate:
TC=
Profit/Loss=
Profit/Loss per Unit=
Price, costs, and revenue
175
$780
$600
$180
$30
MC
150
$130
125
ATC
$110
100
D
75
50
MR
25
Q
0
1
2
3
4
5
6
7
8
9
10
Are
Monopolies
Efficient?
Monopolies are inefficient
because they…
1. Charge a higher price
2. Under produce
• Not allocativly efficiency
3. Produce at higher costs
• No productive efficiency
4. Have little incentive to innovate
Why?
Because there is little external
pressure to be efficient
INEFFICIENCY OF PURE MONOPOLY
An industry in
pure competition
P
S = MC
CS
Pc
PS
D
Qc
Q
INEFFICIENCY OF PURE MONOPOLY
P
S = MC
At MR=MC
A monopolist will
sell less units at a
higher price than in
competition
Pm
Pc
D
MR
Qm
Qc
Q
CS and PS of a Monopoly
P
Result is
DEADWEIGHT LOSS
to society
S = MC
CS
Pm
Pc
PS
D
MR
Qm
Qc
Q
CS and PS of a Monopoly
P
Result is
DEADWEIGHT LOSS
to society
S = MC
CS
Pm
Pc
PS
Monopoly pricing causes consumers
D to
MR
overpay so CS becomes
PS
Qm
Qc
Q
Are Monopolies Productively Efficient?
No. They are not
producing at the lowest
cost (min ATC)
Does Price = Min ATC?
200
Price, costs, and revenue
175
MC
150
ATC
125
100
D
75
50
MR
25
Q
0
1
2
3
4
5
6
7
8
9
10
Do Monopolies Have Allocative Efficiency?
No. Price is greater.
The monopoly is under
producing.
Does Price = MC?
200
Price, costs, and revenue
175
MC
150
ATC
125
100
D
75
50
MR
25
Q
0
1
2
3
4
5
6
7
8
9
10
Regulating
Monopolies
Why Regulate?
Why would the government regulate
an monopoly?
1. To keep prices low
2. To make monopolies efficient
How do they regulate?
•Use Price controls: Price Ceilings
•Why don’t taxes work?
•Taxes limit supply-that’s the problem
Where should the government
place the price ceiling?
1.Socially Optimal Price
P = MC (Allocative Efficiency)
OR
2. Fair-Return Price (Break–Even)
P = ATC (Normal Profit)
REGULATED NATURAL MONOPOLY
Monopoly Price
MR = MC
Price and Costs
P
Pm
ATC
MC
D
MR
Qm
Q
REGULATED NATURAL MONOPOLY
Price and Costs
P
Fair-Return Price
Normal Profit Only
TR = TC
ATC
MC
Pf
D
MR
Qf
Q
REGULATED NATURAL MONOPOLY
Price and Costs
P
Socially-Optimum
Price
P = MC
ATC
MC
Pr
D
MR
Qr
Q
REGULATED NATURAL MONOPOLY
Dilemma of Regulation
MR = MC Which Price?
Fair-Return Price
Price and Costs
P
Pm
Socially-Optimum
Price
ATC
MC
Pf
Pr
D
MR
Qm
Qf
Qr
Q
Price
Discrimination
PRICE DISCRIMINATION
Definition:
Practice of selling the same products
to different buyers at different prices
Requires the following conditions:
•Firm must have monopoly power
•Firm must be able to segregate the market
•Consumers must not be able to resell
product
PRICE DISCRIMINATION
•Price discrimination seeks to charge each
consumer what they are willing to pay in an
effort to increase profits.
•Those with inelastic demand are charged
more than those with elastic
Examples:
•Airline Tickets (vacation vs. business)
•Movie Theaters (child vs. adult)
•All Coupons (spenders vs. savers)
•SPHS soda machine (students vs. teachers)
PRICE DISCRIMINATION
Price and Costs
P
Economic profits with
a single MR=MC
price
MC
ATC
MR
Q1
D
Q
Price and Costs
A perfectly discriminating can charge each person
differently so the Marginal Revenue = Demand
MC
P
ATC
MR=D
D
Q1
Q2
Q
What output do they make?
Where is Consumer Surplus?
MC
Price and Costs
P
ATC
MR=D
D
Q2
Q
Where is the Profit?
Profit with
price discrimination
Price and Costs
P
MC
ATC
MR=D
D
Q1
Q2
Q
What’s the Point?
•Perfectly price discriminating
firms:
•Make more profit
•Produce more
•Produce at allocative efficiency
Allocative Efficiency
MC
Price = MC
Price and Costs
P
ATC
MR=D
D
Q1
Q2
Q
Can You Do The Following?
1.Draw a monopoly making a profit at
long-run equilibrium and identify
price, quantity, and profit.
2. Draw a perfectly competitive
industry AND firm at long-run
equilibrium
3. Draw a price discriminating
monopoly at equilibrium and label
price, quantity, MR, and profit
Monopolistic
Competition
FOUR MARKET MODELS
Monopolistic Competition:
• Relatively Large Number of Sellers
• Differentiated Products
• Some control over price
• Easy Entry and Exit
• Extensive non-price competition
Pure
Competition
Monopolistic
Competition
Oligopoly
Pure
Monopoly
Market Structure Continuum
Examples:
1.
2.
3.
4.
5.
Fast Food Restaurants
Furniture companies
Jewelry stores
Hair Salons
Clothing Manufacturers
“Monopolistic” +”Competition”
Monopolistic Qualities
• Control over price of own good due
to differentiated product.
• D > MR
• Plenty of non-price competition
• Not efficient
Perfect Competition Qualities
• Large number of smaller firms
• Relatively easy entry and exit
• Zero Economic Profit in Long-Run
since firms can enter.
Differentiated Products
• Goods are NOT identical.
• Firms seek to capture a piece of the
market by making unique goods.
• Since these products have substitutes,
firms use NON-PRICE Competition
• Brand Names and Packaging
• Product Attributes
• Service
• Location
• Advertising (Two Goals)
1. Increase Demand
2. Make demand more INELASTIC
Drawing
Monopolistic
Competition
PRICE AND OUTPUT IN
MONOPOLISTIC COMPETITION
MC
What Happens?
Price and Costs
ATC
$4
$2
Short-Run
Economic
Profits
D
MR
Q1
Quantity
PRICE AND OUTPUT IN
MONOPOLISTIC COMPETITION
MC
New Firms Enter
ATC
Price and Costs
In the long-run, new firms will enter,
driving$4down the DEMAND for firms
$2already in the market.
Short-Run
Economic
Profits
D
MR
Q1
Quantity
PRICE AND OUTPUT IN
MONOPOLISTIC COMPETITION
MC
What will happen?
Price and Costs
ATC
$4
$2
Short-Run
Economic
Profits
D
MR
Q1
Quantity
LONG- RUN EQUILIBRIUM
MC
ATC
Price and Costs
Normal Profit
$4
$2
$1
D
MR
Q1
Quantity
Why does DEMAND shift?
• When short-run profits are made…
– New firms enter
– New firms mean more close substitutes and
less market shares for each existing firm.
– Demand for each firm falls
• When short-run losses are made…
– Firms exit
– Result is less substitutes and more market
shares for remaining firms.
– Demand for each firm rises
PRICE AND OUTPUT IN
MONOPOLISTIC COMPETITION
MC
What happens?
Price and Costs
ATC
$7
$1
Short-Run
With Economic
economic
Loss
losses, firms will
exit the market – stability MR
occurs
when economic profits
are zero.
Q
1
Quantity
D
PRICE AND OUTPUT IN
MONOPOLISTIC COMPETITION
MC
What happens?
Price and Costs
ATC
$7
$1
Short-Run
Economic
Loss
D
MR
Q1
Quantity
Price and Costs
PRICE AND OUTPUT IN
MONOPOLISTIC COMPETITION
Long-Run Equilibrium MC
Normal
Profit
Only
ATC
$7
D
MR
Q3
Quantity
MONOPOLISTIC
COMPETITION
AND EFFICIENCY
MONOPOLISTIC COMPETITION
AND EFFICIENCY
• Not Productively Efficient
 Minimum ATC
• Not Allocatively Efficient
Price  MC
• Firm has Excess Capacity
Graphically…
MONOPOLISTIC COMPETITION
AND EFFICIENCY
Price and Costs
Long-Run Equilibrium MC
Price is Not
= Minimum
ATC
ATC
P3
= A3
Price  MC
D
MR
Q3
Quantity
MONOPOLISTIC COMPETITION
AND EFFICIENCY
Excess Capacity
• The gap between the minimum
ATC output and the profit
maximizing output
• Given current resources, the firm
can produce at minimum ATC,
but they decide not to.
MONOPOLISTIC COMPETITION
AND EFFICIENCY
Long-Run Equilibrium MC
Price and Costs
ATC
P3
= A3
Excess Capacity
D
MR
Q3
Quantity
Advantages of
MONOPOLISTIC COMPETITION
• Large number of firms and product
variation meets societies needs
• Nonprice Competition (product
differentiation and advertising) may
result in sustained profits for some
firms.
Ex: Nike might continue to make above
normal profit because they are a well
known brand.
Oligopoly
FOUR MARKET MODELS
Oligopoly:
• A Few Large Producers
• Identical or Differentiated Products
• Control Over Price, But Mutual
Interdependence
•Firms use Strategic Pricing
• High Entry Barriers
• Examples: OPEC, Cereal Companies,
Car Producers
Pure
Competition
Monopolistic
Competition
Oligopoly
Pure
Monopoly
Market Structure Continuum
HOW DO OLIGOPOLIES OCCUR?
Oligopolies occur when only a few
large firms start to control an
industry.
High barriers to entry keep others
from entering.
Types of Barriers to Entry
• Economies of Scale
• High Start-up Costs
• Ownership of Raw Materials
Game Theory
What is game theory?
The study of how people behave in
strategic situations
A thorough understanding of game
theory helps firms in an oligopoly
maximize profit.
Why learn about game theory?
•Oligopolies are interdependent since
they compete with only a few other
firms.
• Their pricing and output decisions
must be strategic as to avoid
economic losses.
•Game theory helps us analyze their
strategies.
SIMULATION!!!!!
The Prisoner’s Dilemma
Charged with a crime, each
prisoner has one of two choices:
Deny or Confess
Prisoner 2
Deny
Both Deny = 3
Deny Years in jail each
Confess
Confess =1 Year
Deny =7 Years
Prisoner 1
Confess = 1 Year
Confess
Deny = 7 Years
Both Confess= 5
Years in jail each
Strategic Pricing
Each firm has one of two choices:
Price High or Price Low.
Firm 2
High
High
Low
Both High =
2 Each
Low = 3
High = 0
Firm 1
Low
Low = 3
High = 0
Both Low=
1 each
OLIGOPOLY BEHAVIOR
A Game-Theory Overview
RareAir’s Price Strategy
Uptown’s Price Strategy
High
A
$12
Low
B
$15
High
$12
C
$6
$6
D
Low
$15
$8
$8
OLIGOPOLY BEHAVIOR
Greatest Combined Profit if both Sell High
RareAir’s Price Strategy
Uptown’s Price Strategy
High
A
$12
Low
B
$15
High
$12
C
$6
$6
D
Low
$15
$8
$8
OLIGOPOLY BEHAVIOR
Each firm recognizes that more profit is made if they
lower price
RareAir’s Price Strategy
Uptown’s Price Strategy
High
A
$12
Low
B
$15
High
$12
C
$6
$6
D
Low
$15
$8
$8
OLIGOPOLY BEHAVIOR
BUT if both lower price they end up in the Worst Case
RareAir’s Price Strategy
Uptown’s Price Strategy
High
A
$12
Low
B
$15
High
$12
C
$6
$6
D
Low
$15
$8
$8
OLIGOPOLY BEHAVIOR
To make more profit, firms may try to cooperate (collude)
RareAir’s Price Strategy
Uptown’s Price Strategy
High
A
$12
Low
B
$15
High
$12
C
$6
$6
D
Low
$15
$8
$8
OLIGOPOLY BEHAVIOR
To make more profit, firms may try to cooperate (collude)
RareAir’s Price Strategy
Uptown’s Price Strategy
High
A
$12
Low
B
$15
High
$12
C
$6
$6
D
Low
$15
$8
$8
OLIGOPOLY BEHAVIOR
But now each firm has the incentive to cheat.
RareAir’s Price Strategy
Uptown’s Price Strategy
High
A
$12
Low
B
$15
High
$12
C
$6
$6
D
Low
$15
$8
$8
What did we learn?
1. Oligopoly pricing must be
strategic
2. Oligopolies have a tendency to
collude to gain profit.
(Collusion is the act of cooperating
with rivals in order to “rig” a
situation.)
3. Collusion results in the incentive
to cheat.
Oligopoly
Graphically
THREE OLIGOPOLY MODELS
Not one standard model due to...
Complications of Interdependence
Instead there are 3 Alternative Models:
1 – Price Leadership (no graph)
2 – Cartels and Collusion (known graph)
3 – Kinked Demand Curve (new graph)
Price
Leadership
PRICE LEADERSHIP MODEL
•Collusion is ILLEGAL.
•Firms CANNOT set prices.
•Price leadership is a strategy used by
firms to coordinate prices without
outright collusion
General Process:
1. “Dominant firm” initiates a price change
2. Other firms follow the leader
Example: 3 competing gas stations.
PRICE LEADERSHIP MODEL
Breakdowns in Price Leadership
• Temporary Price Wars may occur if
other firms don’t follow price
increases of dominant firm.
• Each firm tries to undercut each
other.
Example: Employee Pricing for Ford
Cartels and
Collusion
CARTELS AND COLLUSION
Cartel = Colluding Oligopoly
A cartel is a group of producers that create
a formal agreement to fix prices high.
Examples:
1. Overt Collusion- OPEC ( Organization of
Petroleum Exporting Countries)
11 countries set limits on the supply of oil
2. Covert Collusion- In 1998, Toys R’ Us and Toy
manufacturers were sued by the government for
having secret price fixing meetings.
Characteristics of Cartels
1. Cartels set price and output at an
agreed upon price
2. Firms require identical or highly
similar demand and costs
3. Cartel must have a way to punish
cheaters
4. Together they act as a monopoly
Graphically…
CARTELS AND OTHER COLLUSION
Price and costs
Colluding Oligopolists Will
Split the Monopoly Profits.
Economic
Profit
MC
P0
ATC
A0
D
MR = MC
MR
Q0
Kinked Demand
Curve
Kinked Demand Curve Model
The kinked demand curve model is a graphic
portrayal of the interdependency of noncollusive
firms.
Noncollusive firms are likely to react to
competitor’s pricing in two ways:
1. Match price-If one firm cuts it’s prices,
then the other firms follow suit causing
inelastic demand
2. Ignore change-If one firm raises prices,
others maintain same price causing elastic
demand
KINKED DEMAND THEORY:
The demand and MR curves if
other firms match lower pricing
Price
If this firm lowers
its price and
others follow, Qd
will increase
mildly
D1
Quantity
MR1
KINKED DEMAND THEORY:
Price
The demand and MR curves if
other firms ignore higher pricing
If this firm increases its price
and others ignore it, Qd for this
firm will decrease significantly
D2
MR2
Quantity
Two sets of curves based on the pricing
decisions of other firms
Price
The firm’s demand and
marginal revenue curves
D2
D1
Quantity
MR1
MR2
Two sets of curves based on the pricing
decisions of other firms
Price
Rivals tend to
follow a price cut
D2
D1
Quantity
MR1
MR2
Two sets of curves based on the pricing
decisions of other firms
Price
Rivals tend to
follow a price cut
or ignore a
price increase
D2
D1
Quantity
MR1
MR2
Two sets of curves based on the pricing
decisions of other firms
Price
Effectively creating
a kinked demand curve
D2
D1
Quantity
MR1
MR2
Two sets of curves based on the pricing
decisions of other firms
Price
Effectively creating
a kinked demand curve
D
Quantity
Two sets of curves based on the pricing
decisions of other firms
Price
What about MR?
D2
D1
Quantity
MR1
MR2
Two sets of curves based on the pricing
decisions of other firms
Price
Since we use sections of both
MR curves, the MR has a
vertical gap.
MR2
D
Quantity
MR1
KINKED DEMAND THEORY:
Price
NONCOLLUSIVE OLIGOPOLY
Profit maximization
MR = MC occurs
at the kink.
MR2
D
Quantity
MR1
KINKED DEMAND THEORY:
NONCOLLUSIVE OLIGOPOLY
Price
Notice that changes in costs don’t
easily change profit maximizing
output.
MC1
MR2
MC2
D
Quantity
MR1
KINKED DEMAND THEORY:
NONCOLLUSIVE OLIGOPOLY
The result is stable (or sticky)
prices for noncolluding firms.
Price
MC1
MR2
MC2
D
Quantity
MR1