John Sloman Keith Norris PowerPoint to accompany

John SlomanKeith Norris

PowerPoint to accompany

John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

Purpose of Lecture – Imperfect Competition

• Explain key differences in firm behaviour and market structure:

- Re: Oligopoly compared to Monopolistic Competition.

• So that analysis and comparison can be performed:

– Determination of profit maximising price and output (short and long-run);

– Calculation of normal and supernormal profits (short and long-run);

– Determination of shut-down points (short and long-run).

Imperfect Competition

Chapter 7


Monopolistic Competition• Assumptions of monopolistic competition

• Large number of firms:

– (Each has small share of market – so not affecting rival to any great extent);

• Independence:

– Each firm makes their decision not worried about its affect on rival;

• Freedom of entry:

• Product differentiation:

– Products & services vary across rivals;

– Can raise price without losing all customers;

– Downward sloping demand curve – relatively elastic given large number of competitors consumers can turn to.

– examples in Australia

• Petrol stations, hairdressers, restaurants & builders;

• Many firms in industry but usually only one in a location (retailing, newsagents – local monopoly can charge higher prices)


Monopolistic Competition• Short-Run equilibrium of the firm:

- Figure 7.1 (a) same for monopoly except AR and MR curves more elastic;

- Short run profit max. MC = MR;

- Can make supernormal profit (short-run):

- As does perfectly competitive firm (shaded area);

- Depends on demand strength, position & elasticity;

- Increases with product differentiation;

- Firm’s SR-Profit greater when D curve is less elastic &

further to the right of the AC curve


$

Q 0 Qs

AR D)

MC

AC

MR

Ps

ACs

Short-run Equilibrium of the Firm Under Monopolistic Competition

Economic Profit


Monopolistic Competition

• New firms enter when supernormal profits are being made;

• New firms steal customers from established firms;

• Demand for established firms product falls:- Their D (AR) curve will shift leftwards as

long as supernormal profits remain and new firms keep entering;

• LR equilibrium only normal profits & no incentive for entry (Figure 7.1 (b)) next slide.

• To right of equilibrium, LRAC is > AR and < normal profits are made.


ARL DL)

MRLQ 0 QL

PL

LRAC

LRMC

Long-run Equilibrium of the Firm Under Monopolistic Competition

$


Long-run Equilibrium of the Firm Under Monopolistic Competition

• Non-price competition• Product development:

– To produce a high demand product;– Different from rival’s product;– Better than rivals (personal service, late opening, certain lines

stocked, etc.);– Inelastic demand due to lack of close substitutes;

• Advertising:- To sell the product;- Increases demand and makes the demand curve less elastic (stresses product qualities over that of rivals);

- Optimal advertising is where MRA = MCA;

- As long as MRA > MCA additional advertising will add to profits

- Extra amounts spent on advert. Will lead to smaller & smaller increases in sales;

- Thus MRA falls until it is = MCA, then no further profit can be gained from adverts.


Monopolistic Competition• Product development and advertising effects on D are difficult to forecast.

- Different effects at different prices;

- Profit Max. involves opt. combination of price, product type, advertising level & variety.

• The public interest - comparison with perfect competition:

- Higher price & lower quantity;

- Not producing at least-cost point;

- Therefore have excess capacity (could move to Min. LRAC);

- Large number of firms (petrol stations) all operating at less than optimum output & hence being forced to charge a higher P than could with bigger turnover;

- Difference with Perfect Comp. likely to be small;

- Downward sloping D curve likely to be highly elastic due to large number of substitutes;

- Greater variety of products to choose from;

- each firm may satisfy some particular requirement of particular consumers


Monopolistic Competition• Comparison with monopoly:

- V.similar to comparing monopoly with perfect competition;

- Prices kept down by freedom of entry and lack of supernormal profits (cost savings);

- Less economies of scale than monopoly hence less funds for investment and R&D.

John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education AustraliaQ2

P2 DL under perfect

competition

Q0

P1

LRAC

DL under monopolistic

competition

Q1

Figure 7.2 Long-run Equilibrium of the Firm Under Perfect and Monopolistic Competition

$


Oligopoly• Key features of oligopoly:

- Few firms share large portion of the industry;

- Virtually identical products e.g. metals, chemicals, sugar, petrol) or,

- Differentiated products e.g. cars, soap powder, soft drink, banking services;

- Competition is in brand marketing

(1) Barriers to entry:

– several similar to monopoly (p. 122);

– Vary from industry to industry (some cases easy in others virtually impossible).

(2) Interdependence of the firms:

- Only a few firms each affected by other’s actions - so take account of each other’s

decisions;

- So mutually dependent – very difficult to make predications without knowing how

rivals will react: - no general accepted theory of oligopoly;

(3) Examples in Australia:

- Motor vehicle industry, banking industry, supermarket retailers


Oligopoly

The Banking Oligopoly

Shares of Total Banking Assets, 2006 (%)

Commonwealth Bank 18.6National Australia Bank 18.2Westpac 15.2ANZ 14.6All other banks 33.3


Oligopoly – Two Incompatible Directions:

• Collusion from firm interdependence:

- Cartel acts like a monopoly to jointly maximise profits;

• Competition to gain bigger share of industry profits for themselves causes aggregate profit loss:

- Price competition drives down average industry Price;

- Competition through advertising raises industry costs.

• Equilibrium of the industry:

- For cartel:

(1) Firms agree on prices, market share, advertising exp, etc.

(2) Reduces their uncertainty and fear of competitive price cutting or retaliatory advertising – both could reduce total industry profits;

(3) can compete against each other using non-price competition or allocate quotas. If quota sum > Q1 price would have to fall to clear.


Q 0

Industry D AR

Profit-maximising Cartel

$


Q 0

Industry D AR

Industry MC = Horizontal sum of individual firms

Industry MR

Q1

P1

Profit-maximising Cartel

$


Oligopoly• Tacit collusion

– Firms keep to a price set by established leader (told price), or

– Firms constantly follow leader’s changing prices (follow price):

• Leader may prove reliable to follow - best barometer of market conditions;

• Barometric firm price leadership (barometric firm may change frequently):

– Problems:

• Assumes followers will want to maintain a constant market share;

• Followers may want to supply more at higher price, or

• Followers may decide to maintain market share for fear of retaliation from the leader like price cuts or aggressive advertising campaign.


Q 0

MR leader

AR D leader

AR D market

Assume constantmarket share

for leader

Price Leader Setting Price -Aiming to Maximise Profits for a Given Market Share

$


Q 0

AR D market

MC

MR leader

PL

QT

AR D leader

QL

l t

Price Leader Aiming to Maximise Profits for a Given Market Share

(Barometric method is similar – Although firm not dominating)

$

a


Oligopoly• Tacit collusion – Other forms

– Average cost pricing:

• Add a percentage for profit on top of average costs;

• Used in inflationary times – rule of thump;

– Price benchmarks:

• Will round up to $9.95, $14.95, $19.95 but not $12.31, $16.42, $20.04;

– Both Methods:

• Applied to advertising – no criticism of other products only praise your own (no everlasting light bulb)


Oligopoly• Factors favouring collusion

– Few firms – well know to each other;

– Open with each other about costs & production methods;

– Similar production methods and average costs:• Therefore will want to change prices at same time by same

percent.

– Similar products & can reach price agreements;

– There is a dominant firm;

– Significant entry barriers – little fear of disruption by new firms;

– The market is stable – sets certainty for agreements;

– No government measures to curb collusion.


Oligopoly• Breakdown of collusion is concerned with:

– Price, quantity, advertising & product development;

– Strategy choice depends on anticipated rival reaction & willingness to gamble.

• Game theory:

– Assume 2 firms with identical costs, products and demand;

– Both considering alternative price to charge – table 7.1 shows profit payoffs;

– Maximum and Minimum payoffs;

– Nash equilibrium – equilibrium outcome where there is no collusion between the players;

– Prisoner’s dilemma – tempted to cheat and cut prices from collusion;

– Importance of timing of decisions.


$2.00 $1.80

$2.00

$1.80

X’s price

Y’s price

A B

C D

$10m each

$8m each$12m for Y$5m for X

$5m for Y$12m for X

Profits for Firms A and B at Different PricesTable 7.1


Not confess Confess

Notconfess

Confess

Sue's alternatives

Bill'salternatives

A B

C D

Each gets1 year

Each gets3 years

Bill gets3 monthsSue gets10 years

Bill gets10 yearsSue gets3 months

The Prisoners' Dilemma


Oligopoly

• Ampol promises to match a competitors price within a radius:

- Competitors believe this promise;

- Competitors believe that Ampol will not undercut their price;

- what price for the only other petrol station in region?

- Price that will maximise its profits assuming that Ampol will charge the same price;

- In absence of other providers, is likely to charge a relatively high price;

- Now assume several petrol stations in locality, so what should the company do know?

- Perhaps charge same as Ampol and hope that no other company charges lower forcing Ampol to cut its price?

- Assuming that Ampol’s threat is credible, other companies are likely to reason similarly.


Oligopoly

• Importance of Timing:

- Most decisions are made firms individually rather than similtaneously;

- Sometimes an individual firm will take the initiative at other times it will respond to the decision of the other firms;

- The following decision try illustrates this:

- Assume a market for both a 500 seater and 400 seater version of new type of aircraft;

- But not big enough for two airlines – Boeing and Airbus;

- Assume:

(1) 400 seater => $50m annual profit to single manufacturer;

(2) 500 seater => $30m annual profit to single manufacturer;

(3) If both manufacturers produced the same version they would each make an annual loss of $10m

- There is clearly a first mover advantage in decision tree:

(1) Once Boeing decides to build the more profitable version of the plane, Airbus is forced to build the less profitable version;

(2) Naturally, Airbus would like to build the more profitable version, and be the first mover;

(3) Which airline moves first depends on their advanced R&D and production capacity


Boeingdecides

500

seat

er

500 seater

500 seater

400 seater

400 seater

400 seater

Boeing –$10mAirbus –$10m

(1)

Boeing +$30mAirbus +$50m

(2)

Boeing +$50mAirbus +$30m

(3)

Boeing –$10mAirbus –$10m (4)

Airbusdecides

B2

Airbusdecides

B1

A

A Decision Tree


Oligopoly• More complex decision trees:

– The ‘game’ becomes more like chess;

– With many moves and several options on each move;

– Greater than two companies the decision tree becomes more complex still;

• More complex ‘games’ can be devised:

- With more than two firms, many alternative prices, differentiated products, and various forms of non-price competition (e.g. advertising);

- In such cases, the cautious (maximin) strategy may suggest a different policy (e.g. do nothing) from high risk (maximax) strategy (e.g. cut prices substantially);

- Firms can alter their tactics in the light of new circumstances;

- They may compete for a while, then realise that no one is winning, then jointly raise prices and reduce advertising;

- Later, after a period of tacit collusion, competition may break out again;

- Caused by entry of new firms;- New product designs;- Change in market demand;- Temptation to cheat.


Oligopoly – Non-Collusive & the kinked demand curve• Oligopolists face a kinked demand curve during price wars and are therefore

reluctant to change their prices:

• One oligopolist cuts its price:

• Rivals will feel forced to follow suit to prevent losing customers to the first firm;

• One oligopolist raises its price:

• Rivals will not follow suit to gain customers from the first firm;

• Kinked demand curve at current price and output (Figure 7.6):

– Rise in price: (1) Large sales revenue fall as customers switch to lower priced rivals;

(2) Hence a reluctance to raise price;

(3) Demand is relatively elastic above the kink;

– Fall in price (1) Brings only modest sales increase;

(2) Because rivals lower their prices to and customers do not switch;

(3) Firm is reluctant to reduce its price;

(4) Demand is relatively inelastic below the kink


$

QO

P1

Q1

Current priceand quantity

give one pointon demand curve

Kinked Demand for a Firm Under Oligopoly


QO

P1

Q1

D

D

Kinked Demand for a Firm Under Oligopoly

$


QO

P1

Q1

MC2

MC1

MR

a

bD AR

Stable Price Under Conditions of a Kinked Demand Curve

$


Oligopoly and the Consumer

• Oligopolistic firms are also reluctant to change prices because it:

– Involves modifying price lists;

– Working out new revenue predications;

– Revaluing stock of finished goods;

– May upset customers;

– Colluding like monopoly to charge high prices – not in consumer interest.


Oligopoly and the Consumer• More of a disadvantage than monopoly for consumer:

- May be less scope for economies of scale to mitigate the effects of market power;

- Oligopolists are likely to engage in more extensive advertising than monopolist;

- These are less severe with no oligopolistic collusion, some price competition and weak barriers to entry;

- Oligopolistic power can be offset (in some markets) if they sell their product to other powerful

firms (supermarket – countervailing power).


Oligopoly and the Consumer• Oligopolistic advantages over other market structures:

- Can use part of supernormal profit for R&D (like monopolies);

- have considerable incentive to do so (unlike monopolies);

- product improvement results in greater market share and rivals may take some time to respond;

- Lowered costs from technological improvement => higher profits => withstand price war;

- More consumer choice from product differentiation;(car stereo equipment & non price competition);

- Difficult to draw general conclusion, since oligopolies differ so much in performance.


Price Discrimination• Meaning of price discrimination:

• Different prices for different population groups (markets) when production costs do not vary.

– First degree:• Approximate examples in Australia could include bargaining

at market stalls, and some services.

– Second degree:• Examples in Australia include water, electricity,

bulk buying.

– Third degree (the most common form):• Examples in Australia include cinema tickets, airline tickets,

rail and bus tickets (adults, children, pensioners, etc.)


Price Discrimination• Conditions necessary for price discrimination:

- Firms must be able to determine own price (not price takers such as in perfect competition);

- Separate markets – consumers in one market cannot resell in another market at increased price (children’s tickets resold as adult tickets);

- Differing demand elasticities in each markets;

(1) A higher price where demand is less elastic and hence less sensitive to price rise.


Price Discrimination

• Advantages to the firm:

- Earns higher revenue from any given level of sales (Figure 7.7)

- Drive competitors out of business - Predatory pricing

(1) A monopoly in one market (e.g. home market) may charge a high price due to its

relatively inelastic demand and thus make high profits;

(2) If it is under oligopoly in another market (e.g. export market) it may use the high

profits in the first market to subsidise a very low price in the oligopolistic market,


P

QO

P1

D

200

Revenue froma single price

Third-degree Price Discrimination


O

P1

D

200

P2

150

P

Q

Increased revenuefrom price

discrimination

A higher discriminatoryprice is now introduced

Third-degree Price Discrimination (Figure 7.7)


0 0 0MRX

(a) Market X

DX

Profit-maximising Output UnderThird-degree Price Discrimination (Box 7.4)


0 0 0

DY

MRX

MRY

(a) Market X (b) Market Y

DX



0 0 0MRX

MRY MRT

(a) Market X (b) Market Y (c) Total

(markets X + Y)

DX

DY



0 0 0MRX

MRY MRT

MC


(markets X + Y)

DX

DY

Profit-maximising Output UnderThird-degree Price Discrimination (box 7.4)


0 0 0MRX

MRY MRT

MC


(markets X + Y)

DX

3000

DY



0 0 0

DX

MRX

MRY MRT

MC

5


(markets X + Y)

3000

DY



0 0 0MRX

MRY MRT

MC

5

1000


(markets X + Y)

DX

3000

DY



0 0 0MRX

MRY MRT

MC

5

1000 2000


(markets X + Y)

DX

3000

DY

Profit-maximising output underthird degree price discrimination (Box 7.4)


0 0 0MRX

MRY MRT

MC

5

9

1000 2000


(markets X + Y)

DX

3000

DY

Profit-maximising Output UnderThird-degree Price Discrimination (box 7.4)


0 0 0MRX

MRY MRT

MC

DY

5

7

1000 2000 3000


(markets X + Y)

9

DX



Price Discrimination and the Consumer

• Some benefit and others lose;

• Those paying the higher price will feel unfairly treated;

• Those charged the lower price may be able to obtain a good or service they could otherwise not afford:

- Concessionary bus fares for senior citizens.

• Allows for increased profits and sometimes less competition

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John Sloman Keith Norris PowerPoint to accompany