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Market Structure: Perfect Competition, Monopoly and Monopolistic Competition Slide 1 • What is Market Structure? » » » » Market structure is the competitive environment. Number of buyers and sellers. Potential entrants. The degree of mobility of resources - Barriers to entry and exit, etc. » Type of product bought and sold » The degree of knowledge (economic agents) • Vital Role of Potential Entrants » Competition comes from actual and potential competitors. » Potential entrants often affect price/output decisions. Slide 2 Factors that Shape the Market Structure Environment • Product Differentiation » R&D, innovation, and advertising are important in many markets. • Production Methods » Economies of scale can preclude small-firm size. • Entry and Exit Conditions » Barriers to entry and exit can shelter incumbents from potential entrants. • Buyer Power/Seller Power » Powerful buyers can limit seller power Slide 3 Pure (Perfect) Competition Monopolistic Competition Oligopoly Monopoly Less Competitive More Competitive Market Structure Slide 4 The Strategy Process Prerequisite Knowledge 1. Customers 2. Competitors 3. Market Conditions 4. Capital Raising 5. Resource Availability 6. Socio-political Constraints Slide 5 The Strategy Process Prerequisite Knowledge Components of the Business Model 1. Target Market 1. Customers 2. Value Proposition 2. Competitors 3. Role of Value 3. Market Conditions 4. Revenue Sources 4. Capital Raising 5. Markets Defined 5. Resource Availability 6. Network Value 6. Socio-political Constraints 7. Investment Required 8. Competitive Strategy Slide 6 The Strategy Process Prerequisite Knowledge Components of the Business Model Decisions 1. Target Market 1. Customers 2. Value Proposition 1. Products 2. Competitors 3. Role of Value 2. Prices 3. Market Conditions 4. Revenue Sources 3. Marketing Plans 4. Capital Raising 5. Markets Defined 4. Supply Chains 5. Resource Availability 6. Network Value 5. Distribution Channels 6. Socio-political Constraints 7. Investment Required 6. Projected Cash Flows to Lenders and Equity Owners 8. Competitive Strategy Slide 7 Generic Types of Strategies to Attain Sustainable Profits • Product Differentiation Strategy » So distinguish one’s products from the rest that the other products do not appear to be close substitutes » For example, Coca-Cola or Nestlé • Cost-based Strategies » Find ways to have the lowest cost (and provide the lowest price) in the industry » For example, Southwest Airlines & Dell Computers • Information Technology Strategy » Use IT capabilities to distinguish yourself from others » For example, Allstate Insurance & GPS tracking to offer lower insurance rates to those who don’t drive their best cars to work Slide 8 The Relevant Market Concept • A market is a group of economic agents that interact in a buyer-seller relationship. The number and size of the buyers and sellers affect the nature of that relationship. • A popular measure of concentration is the percentage of an industry comprised of the top 4 firms. Similarly, the market share held by the top 4 buyers is a popular measure of buyer concentration. • The relationship among firms is affected by: a. the number of firms and their relative sizes. b. whether the product is differentiated or standardized. c. whether decisions by firms are independent or coordinated (collusion). Slide 9 Michael Porter’s Five Forces of Competitive Advantage The forces that determine competitive advantage are: 1. Substitutes (threat of substitutes can be offset by brands and special functions served by the product). 2. Potential Entrants (threat of entrants can be reduced by high fixed costs, scale economies, restriction of access to distribution channels, or product differentiation). 3. Buyer Power (threat of concentration of buyers). 4. Supplier Power (threats from concentrated suppliers of key inputs affect profitability). 5. Intensity of Rivalry (market concentration, price competition tactics, exit barriers, amount of fixed costs, and industry growth rates impact profitability). Slide 10 Potential entrants Substitutes Value-price gap Branded vs. generic Sustainable industry profitability High capital requirements Economies of scale Absolute cost advantages High switching costs Lack of access to distribution channels Product differentiation Public policy constraints Intensity of rivalry Buyer power Industrial concentration Pricing tactics Switching costs Exit barriers Cost fixity Industrial growth rates Buyer concentration Overcapacity Homogeneity of buyers Potential of integration Outside alternatives Supplier power Unique suppliers Number of suppliers Supply shortages or surplus Degree of vertical integration Slide 11 Break-even Sales Change Analysis • • • • The price-cost margin percentage (PCM) is defined as PCM = ( P – MC )/P. A price cut may help or hurt profitability depending on price elasticities and price cost margins. We can ask how much quantity must change after a price cut to breakeven (from before the price cut)? If we cut prices 10%, to breakeven the percentage change in quantity (DQ/Q) must be large enough to satisfy the equation to breakeven: PCM / (PCM – .10) < (1 + DQ/Q ) • • • The larger is the price-cost margin percentage, the smaller will be the necessary quantity response to justify cutting price. If PCM is 80%, then .8/(.8-.1) = 1.14. Hence, a 10% cut in price must be offset by at least a 14% increase in quantity to breakeven. If PCM is only 20%, then .2/(.2-.1) = 2. Hence, a 10% cut in price must be offset by at least a 20% increase in quantity to breakeven. Slide 12 There is a continuum of market structures: Pure (perfect) Monopolistic Competition Competition Oligopoly Best Monopoly Worst Pure (Perfect) Competition assumes: 1. 2. 3. 4. 5. 6. a very large number of buyers and sellers Buyers and sellers are price takers homogeneous product (standardized) Economic agents have complete knowledge of all relevant market information free entry and exit (no barriers) - Perfect mobility of resources Example: Stock Market These assumptions imply several things about competitive markets, including price equals marginal cost. Slide 13 Monopoly assumes: 1. 2. 3. 4. 5. 6. Only one firm (seller) in the market area and many buyers No close substitute for product Low cross price elasticity with other products. No interdependence with other competitors. Substantial entry barriers Significant barriers to resource mobility » » » » Control of an essential input Patents or copyrights Economies of scale: Natural monopoly Government franchise: Post office These assumptions imply that the monopoly price is well above marginal cost. Slide 14 3. Monopolistic competition assumes: 1. 2. 3. 4. 5. A large number of firms, some of which may be dominant in size Differentiated products Independent decision making by individual firms Easy entry and exit – perfect mobility of resources Example: Fast-food outlets These assumptions imply several things about monopolistic competition, including that the price in the long run is equal to average cost. Slide 15 Oligopoly assumes: 1. Only a few firms in the market area 2. Products may be differentiated or undifferentiated (homogeneous) 3. There is a large degree of interdependence with other competitors 4. Barriers to resource mobility 5. Example: Automobile manufacturers • These assumptions imply several things about monopolies, including that the monopoly price is well above marginal cost. • After going briefly over these four market structures, this chapter examines: » Pure Competition » Monopolistic Competition Slide 16 Pure Competition and Monopolistic Competition • Pure competition is a standard against which other market structures are compared. The product is perfectly undifferentiated. • When there are many firms, but the product is differentiated, the market is monopolistically competitive. » This brand competition may involve advertising campaigns and large promotional expenditures to stress often minor distinctions among products 2008 Thomson * South-Western Slide 17 Price-Output Determination Under Pure Competition Competitive firms attempt to maximize profits. Competitive firms cannot charge more than the market price of others, since their product is identical to all others. Hence, competitive firms are price takers. Total revenue, TR, is P·Q, where price is given. Therefore, marginal revenue, MR, is price, P. Profit is total revenue minus total cost = TR - TC). Slide 18 Profit maximization implies that each firm produces an output where Price = Marginal Cost (P = MC). » To produce more than this quantity implies that P < MC, which is not the most profitable decision. » To produce less than where P=MC, implies that P > MC, and the firm could increase profits by expanding output. • In short run, a competitive firm may earn economic profits. • In long run, entry pushes price down to the minimum point of the average cost curve, so that economic profits are zero. Slide 19 A Competitive Market in the Short Run 1. If P = MC for each firm, then each firm is doing what it thinks maximizes profits. Firms are in equilibrium. 2. Equilibrium for the industry if: Demand equals Supply at the going price • In this example, the firm is earning economic profits as PSR > AC. » When both (1) & (2) occur, the market is in a Competitive Equilibrium MC MC PSR AC D a firm the industry CAN EARN ECON PROFITS IN THE SHORT RUN Slide 20 Perfect Competition: Price Determination Slide 21 Perfect Competition: Price Determination QD 625 5P QD QS QS 175 5 P 625 5P 175 5P 450 10P P $45 QD 625 5P 625 5(45) 400 QS 175 5P 175 5(45) 400 22 Slide 22 Perfect Competition: Short-Run Equilibrium Firm’s Demand Curve = Market Price = Marginal Revenue Firm’s Supply Curve = Marginal Cost where Marginal Cost > Average Variable Cost 23 Slide 23 Perfect Competition: Short-Run Equilibrium Top panel - d is the demand curve = P = MR -The best level of output at point E, where MC intersects with d or MR -P = $45 and ATC = $35, profit = $10 Bottom panel -At demand curve; d – the best level of output is 3 and loss $10 (FE’) – P = $25 and ATC = $35 -At point E’ the minimizes losses -At point H – shut-down point 24 Slide 24 A Competitive Market in the Long Run • Industries which have economics profits draw entry and shift the MC1 curve out to MC2 where there is no reason for more firms to enter or firms to exit the industry • Price covers all cost, so in the LR, P=AC which means that Economic Profits are zero. MC1 MC AC MC2 entry PLR D a firm the industry ZERO ECON PROFITS IN THE LONG RUN Slide 25 Long Run Competitive Markets with external diseconomies of scale $/barrel for oil Brazilian Ethanol Mexican Oil Persian Gulf Oil D1 • As demand rises for products, we find that inputs become more expensive. The rising cost is not due necessarily to the productivity of the firms, but higher prices for what they purchase. • One example is the rising price for crude oil. D2• As demand in the world increase, the marginal seller of oil is ever pricier. Quantity in million barrels per day Slide 26 Long Run Equilibrium in an Increasing Cost Industry AC2 Price MC AC1 Price MC1 LRS P2 P1 D2 Firm Level D1 Industry Level As demand shifts from D1 to D2, the price rises to P2 and the long run supply curve is upward rising. The cause is the upward shift in AC that firms experience. Slide 27 Perfect Competition: Long-Run Equilibrium Quantity is set by the firm so that short-run: Price = Marginal Cost = Average Total Cost At the same quantity, long-run: Price = Marginal Cost = Average Cost Economic Profit = 0 28 Slide 28 Perfect Competition: Long-Run Equilibrium -Point E* [P=MR=LMC=LAC (lowest)] – best level of output at P=$25, Q=4 -All profits and losses have been eliminated – because of free or easy entry into the market 29 Slide 29 PROBLEM: The following is given: For the industry: QS = 3000 + 200 P and QD = 13500 - 500 P For the firm: FC = 50 MC = 3 Q FIND OPTIMAL output for this firm. Slide 30 Answer: First find the equilibrium price. Set D = S, where: 3,000 + 200 P = 13,500 - 500 P. This implies: 700 P = 10,500 or: 10,500 / 700 = P = $15. At this price, the firm produces where P = MC, and because MC = 3Q P = 15 = 3 Q Q=5 Slide 31 Monopolistic Competition • Many sellers of differentiated (similar but not identical) products • Limited monopoly power • Downward-sloping demand curve • Increase in market share by competitors causes decrease in demand for the firm’s product Product Differentiation Among Gas Stations Slide 32 Product Differentiation • Differentiation occurs when consumers perceive that a product differs from its competition on any physical or nonphysical characteristic, including price. • Examples: restaurants, dealer-owned gas stations, Video rental stores, book & convenience stores, etc. • Assumptions of the Model: » Large number of firms » Differentiated Product » Conditions of Cost and Demand are Similar » Easy Entry & Exit Slide 33 Basic Model of Monopolistic Competition MC • In the Short Run » produce where MR= MC » price on the demand curve • NOTICE: PM AC » P > MC » economic profits exist P > AC » there exists incentives for entry into this industry SHORT RUN DIAGRAM D QM MR Slide 34 Profits in the SR Induces Entry • Entry in this industry “steals” customers. • Demand curve shifts inward • RESULTS » MR = MC (like monopoly) P » P = AC (like competition) » Profits in LR are zero (like competition) » not at Least Cost Point of AC curve (like monopoly) MC AC D D’ Q MR LONG RUN DIAGRAM Slide 35 Monopolistic Competition: Short-Run Equilibrium -The best level of output = 6 units at point E, where MR=MC -At Q=6, P=$9 (point A on the D curve) and ATC=$7 (point F) – monopolistic competition earns a profit of AF=$2 per unit; AFBC=$12 in total (the shaded area) Slide 36 Monopolistic Competition: Long-Run Equilibrium Profit 0 The best level of output of monopolistically competitive firm in long run – 4 units at point E’ At MR’=LMC=SMC’ and P=LAC=SATC’=$6 (point A’) – the firm breaks even Compares to the best level of output of 7 units given by point E”, at MR’=LMC and P=LAC=$5 (point E”) under long run perfectly competitive market equilibrium Slide 37 Properties of Monopolistic Competition • Inefficient Production » EXCESS CAPACITY • not at least cost point of AC curve » Could Avoid Excess Capacity by JOINTLY PRODUCING at the same plant Slide 38 Selling and Promotional Expenses • Suppose that the price is determined outside of the model, as with liquor prices in some States. • We will expand promotional activities until the extra profit associated with the activity equals the extra cost of the promotion. • This decision rule for Optimal Advertising is when: Contribution Margin = Marginal Cost of Advertising or P – MC = k • DA/DQ or expand advertising whenever (P – MC)( DQ/DA) > k • where, contribution (P – MC) is the marginal profit contribution of an additional sale, and the marginal cost of advertising is ( k • DA/DQ). Slide 39 Example: Radio Advertising • To sell one more unit of output will cost the price of the added message, k, divided by the marginal product of a dollar of advertising (DQ/DA). • If a radio message costs $1000, and if that message yields 5 new items sold, then the marginal cost of advertising is $200, ($1000 /marginal product of advertising). • If it costs $200 to sell one more car (MCA=$200), and if the contribution of another car sold is $300 to profits, then we should expand promotional expenses. Slide 40 Competitive Markets Under Asymmetric Information • Used car: who knows what about it? The buyer or the seller? • Asymmetric Information -- unequal or dissimilar knowledge among market participants. • Incomplete Information -- uncertain knowledge of payoffs, choices, or types of opponents a market player faces. Slide 41 Search Goods versus Experience Goods • Search goods are products or services whose quality is best detected through a market search. • Experience goods are products and services whose quality is undetected when purchased. • Warranties and firm reputations are used to assure quality. • But if someone is selling his or her car, isn't it likely that the car is no good? Is it a lemon? » This is an explanation why used car prices are so much lower than new car prices. • If one firm defrauds customers, how do the reputable firms signal that they are NOT like the fraudulent firm? Slide 42 Adverse Selection and the Notorious Firm • Suppose that a firm may decide to produce a High Quality or Low Quality product, and the buyer may decide to offer a High Price or a Low Price. • Since the firm fears that if it offers a High Quality product but that buyers only offer a Low Price, they only produce Low Quality products and receive Low Prices. • This is the problem of adverse selection Slide 43 Notorious Firm Analysis Payoffs in the boxes are for the seller only • Simultaneous decisions BUYER of buyer & seller Hi Price Low Price • A risk averse decision High by the firm is to make a 70 Quality 130 Low Quality product SELLER • Best for the buyer is a Low 150 90 Quality low price, but a high quality good. Worst for We end in a trap of only the buyer is a high price poor quality goods at but a low quality good. low prices. Slide 44 Solutions to the Problem of Adverse Selection • Regulation (Disclosure Laws, Truth in Lending) • Long term relationships, or reliance relationships • Brand names (a form of a “hostage” to quality) • Nonredeployable assets are assets that have little value in another other use Example: Dixie Cups made with paper-cup machinery which cannot be used for other purposes — if Dixie Cups leak, the company is in trouble Slide 45 Credible Commitments • A credible commitment is a conditional strategy for establishing trust by promising to make the promise-giver worse off by violating that trust » such as a promise of product replacement if the product ever fails. Examples: 1. 2. 3. Donney & Bourke promise replacement of handbags Other firms have sometime promised: If any of my products fail to work, I will pay the buyer three-times their purchase price in recompense! Clearly, this commitment makes the firm worse off if they sell shoddy goods. Brand names are a “bond” or “hostage” lost if products fail to live up to promises. Slide 46 Mechanisms for commitments • Use of nonredeployable assets such as reputation. Once lost, a good reputation is hard to rebuild. • Entering into alliance relationships which would fall apart if any party violated their commitments. • using a "hostage mechanism" that is irreversible and irrevocable can deter breaking commitments. » Examples are "double your money back guarantees," and "most favored nation" clauses. Slide 47