Market Structure & Pricing

8/8/2019 Market Structure & Pricing

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MARKET STRUCTURE

NATURE & PRICING OFPERFECT AND MONOPOLYMARKET COMPETITION

BY- ANUJ


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Market StructureIDE NT IFIES HOW A M ARK E T IS M ADE UP IN TE R MS OF:

The numb er of fir ms in t he indust ry

The natu re of the pr oduct p r oduc e dThe degree of monopol y pow er e ac h fir m hasThe degree to w hich the fir m can influ e nc e pr icePr ofit leve lsFir ms b eh a viou r p r icing st r at eg ie s, non -pr ice

comp e tition, output l eve lsThe ex te nt of ba rr ier s to e ntryThe impact on e fficie nc y


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Market Structure

More competitive (fewer imperfections)

PerfectCompetition

PureMonopoly


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Market Structure

L ess competitive (greater degree of imperfection)

PerfectCompetition

PureMonopoly


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Market StructurePerfect

Competition

PureMonopoly

Monopolistic Competition Oligopoly Duopoly Monopoly

The further right on the scale, the greater the degree of monopoly power exercised by the firm.


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Market StructureImpor tanc e :Degree of comp e tition aff e cts t he consum er will it be ne fit the consum er or not?Impacts on t he per for manc e and b eh a viou r of the compan y/compani e s in volve d


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Market StructureModels a word of warning! Ma rke t st r uctu re de als wit h a numb er of e conomic mod e ls The s e mod e ls a re a re pre s e ntation of re ality to he lp us to

und er stand w hat ma y be happ e nin g in re al lif e There a re ex tre me s to t he mod e l that a re unlike ly to occu r in

re ality They still ha ve valu e as t hey e nabl e us to d r aw compa r isons

and cont r asts wit h what is obs erve d in re ality

Mod e ls he lp there fore in anal ysin g and ev aluatin g they off er a b e nc hma rk


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Market StructureCh aracteristics of eac h model: Numb er and siz e of fir ms t hat ma ke up t he

indust ry Cont r ol o ver pr ice or output F ree dom of e ntry and ex it f r om t he indust ry Natu re of the pr oduct d egree of homo ge ne ity

(simila r ity) of t he pr oducts in t he indust ry (ex te nt towhich pr oducts can b e reg a r de d as substitut e s fo r e ac h other)

Dia gr ammatic re pre s e ntation t he s hap e of the de mand cu rve , e tc.


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Market StructureCharacteristics: L ook at these everyday products what type of market structure are the producers of these products operatingin?

Remember tothink about thenature of theproduct, entry andexit, behaviour of the firms, numberand size of thefirms in theindustry.

You might evenhave to ask whatthe industry is??Canon SL R Cam er aBananas

Mer ce de s CL K Coup e

Vod ka

Ele ctr icGuita r J azz Bod y


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Perfect CompetitionOne ex tre me of the ma rke t st r uctu re sp e ct r um

Ch aracteristics: La rge numb er of fir ms Pr oducts a re homo ge nous (id e ntical ) consum er has no

re ason to ex pre ss a p re f ere nc e for an y fir m F ree dom of e nt ry and ex it into and out of t he indust ry Fi r ms a re pr ice ta ker s ha ve no cont r ol o ver the pr ice they

cha rge for the ir pr oduct Eac h pr oduc er suppli e s a very small p r opo r tion of total

indust ry output Consum er s and p r oduc er s ha ve per f e ct knowl e dge about

the ma rke t


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Perfect CompetitionDiagrammatic representationCost/Revenue

Output/Sales

The indust ry pr ice isde ter mine d b y the de mandand suppl y of the indust ry as a w hole . The fir m is avery small suppli er withinthe indust ry and has nocont r ol o ver pr ice . They wills e ll e ac h ex tr a unit fo r the sam e pr ice . Pr ice there fore = MR and AR

P = MR = AR

MC

The MC is t he cost of pr oducin g additional(ma rg inal ) units of output. Itfalls at fi r st (du e to t he law of diminis hing re tur ns ) the n r ise sas output r ise s.

AC

The a ver age cost cu rve is t he standa r d U shap e d cu rve .MC cuts t he AC cu rve at itslowe st point b e caus e of the mat he matical re lations hipbe twee n ma rg inal and a ver a ge valu e s.

Q1

Give n the assumption of p r ofitma ximisation, t he fir m p r oduc e sat an output w here MC = M R (Q1 ). Th is output l eve l is af r action of t he total indust ry suppl y.

At this output t he fir m isma king no r mal p r ofit.Th is is a lon g r uneq uilibr ium position.


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Perfect CompetitionDiagrammatic representationCost/Revenue

Output/Sales

P = MR = AR

MC

AC

Q1

Now assum e a fir m ma ke ssom e for m of modification toits p r oduct o r gains som e for mof cost ad vanta ge (sa y a n e wpr oduction m e thod ). W hat

would happ e n?

AC1

MC1

AC1Abnormal profit

Q2

Be caus e the mod e l assum e sper f e ct knowl e dge , the fir mgains t he ad vanta ge for only as hor t tim e be fore other s cop y the ide a o r a re att r act e d to t he indust ry by the ex iste nc e of abno r mal p r ofit. If ne w fir mse nter the indust ry, suppl y willincre as e , p r ice will fall and t he fir m will b e le ft ma king no r malpr ofit onc e a gain.

P1 = MR1 = AR1

The lower AC and MC wouldimply that t he fir m is nowe a r ning abno r mal p r ofit( AR>A C) re pre s e nte d b y the grey a re a.

Aver a ge and Ma rg inal costscould b e ex pe cte d to b e lower but p r ice , in t he s hor t r un,re mains t he sam e .


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Monopolistic or Imperfect Competition

Where the conditions of p er f e ct comp e tition

do not hold, imper f e ct comp e tition will ex istVa rying degree s of imp er f e ction give r ise tova rying ma rke t st r uctu re sMonopolistic comp e tition is on e of the s e not to b e confus e d wit h monopol y!


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Monopolistic or Imperfect CompetitionCh aracteristics: La rge numb er of fir ms in t he indust ry

Ma y ha ve som e e le me nt of cont r ol o ver pr ice du e to t he fact t hat t hey a re abl e to diff ere ntiat e the ir pr oduct in som e wa y f r om t he ir r ivals p r oductsa re there fore clos e , but not p er f e ct, substitut e s

Ent ry and ex it f r om t he indust ry is re lative ly e as y

f e w ba rr ier s to e ntry and ex it Consum er and p r oduc er knowl e dge imp er f e ct


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Monopolistic or Imperfect CompetitionImplications fo r the dia gr am:

Cost /Reve nue

Output / Sal e s

MC

AC

Ma rg inal Cost and Aver a ge Cost will b e the sam e s hap e . How ever ,be caus e the pr oducts

a re diff ere ntiat e d insom e wa y, t he fir m willonly be abl e to s e ll ex tr aoutput b y lower ing pr ice .

D (AR)

The de mand cu rve facin g the fir m will b e downwa r dslopin g and re pre s e nts t he AR e a r ne d f r om sal e s.

MR

Sinc e the additionalreve nue re ce ive d f r ome ac h unit sold falls, t he MR cu rve lie s und er the AR cu rve .

We assum e that t he fir mpr oduc e s w here MR = MC(p r ofit ma ximisin g output ). At this output l eve l, AR>A C

and t he fir m ma ke sabno r mal p r ofit (the grey s had e d a re a ).

Q1

1.00

0.60

Abno r mal Pr ofit

If the fir m p r oduc e s Q1 ands e lls e ac h unit fo r 1.00 ona ver a ge with the cost (ona ver a ge) for e ac h unit b e ing 60p, t he fir m will ma ke 40p x Q1 in abno r mal p r ofit.

Th is is a s hor t r un eq uilibr iumposition fo r a fir m in amonopolistic ma rke tst r uctu re .


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Monopolistic or ImperfectCompetitionImplications for the diagram:

Cost/Revenue

Output / Sales

MC

AC

D (AR)MRQ1

Be caus e there is re lative f ree dom of e ntry and ex itinto t he ma rke t, ne wfir ms will e nter

e ncou r age d b y the ex iste nc e of abno r malpr ofits. Ne w e ntr ants willincre as e suppl y causin g pr ice to fall. As p r ice falls,the AR and M R cu rve ss hift inwa r ds as reve nue f r om e ac h sal e is nowle ss.

AR1MR1


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Cost/Revenue

Output / Sales

MC

AC

D (AR)MRQ1

AR1MR1

Notic e that t he ex iste nc e of mo re substitut e s ma ke sthe ne w AR (D) cu rve mo re pr ice e lastic. The

fir m re duc e s output to apoint w here MC = M R (Q2 ). At this output AR = AC and t he fir m will ma ke no r mal p r ofit.

Q2

AR = AC


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Cost/Revenue

Output / Sales

MC

AC

AR1MR1

Th is is t he long r uneq uilibr ium position of afir m in monopolisticcomp e tition.

Q2

AR = AC


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Som e impo r tant points about monopolisticcomp e tition:

Ma y re fle ct a wid e r an ge of ma rke ts Not just on e point on a scal e re fle cts man y

degree s of imper f e ction E xampl e s?


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Re stau r antsP lumb er s /e le ctr icians /local build er sSolicitor sPr ivat e sc hoolsP lant hire fir msInsur anc e br oker sHe alt h clubs

Hair dre ss er sFuner al di re cto r sEstat e a ge ntsDamp p r oofin g cont r ol fir ms


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Ine ac h cas e there a re man y fir ms in t he indust ryEach can t ry to diff ere ntiat e its p r oduct in som e wa y

Entry and ex it to t he indust ry is re lative ly f reeConsum er s and p r oduc er s do not ha ve per f e ctknowl e dge of t he ma rke t the ma rke t ma y ind ee d b e re lative ly localis e d can you ima gine trying to s e a r ch out t he de tails, p r ice s, re liability, qualit y of s erv ice , e tc

for every plumb er in the UK in the eve nt of ane merge nc y??


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Oligopoly Comp e tition b e twee n t he f e w Ma y be a la rge numb er of fir ms in t he indust ry but

the indust ry is dominat e d b y a small numb er of very large pr oduc er sC oncentration Ratio the pr opo r tion of totalma rke t sal e s (s ha re) he ld b y the top 3,4,5, e tcfir ms: A 4 fir m conc e ntr ation r atio of 75% m e ans t he top

4 fir ms account fo r 75% of all t he sal e s in t he indust ry


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Oligopoly Exampl e :Music sal e s

The music industry hasa 5 firm concentrationratio of 75%.Independents make up25% of the market butthere could be manythousands of firms thatmake up this

independents group.An oligopolistic marketstructure thereforemay have many firmsin the industry but it isdominated by a fewlarge sellers.

Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html


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Oligopoly Fe atu re s of an oli gopolistic ma rke t st r uctu re : Pr ice ma y be re lative ly stabl e ac r oss t he indust ry kinke d d e mand cu rve ? P ote ntial fo r collusion Beh a viou r of fir ms aff e cte d b y what t hey be lieve the ir r ivals mi gh t do

inter de pe nd e nc e of fir ms Goods could b e homo ge nous o r high ly diff ere ntiat e d Br andin g and b r and lo yalty ma y be a pot e nt sou r ce of comp e titive

ad vanta ge Non -pr ice comp e tition ma y be prev ale nt Gam e the ory can b e us e d to ex plain som e beh a viou r

AC cu rve ma y be sauc er s hap e d minimum e fficie nt scal e could occu r over la rge r an ge of output High ba rr ier s to e ntry


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Oligopoly The kinked demand curve - an explanation for price stability?Price

Quantity

D = elastic

D = Inelastic

5

100

Kinked D Curve

The pr inciple of the kinke d d e mandcu rve re sts on t he pr inciple that:

a. If a fi r m r ais e s its p r ice , its

r ivals will not follow suitb. If a fi r m low er s its p r ice , its

r ivals will all do t he sam e

Assum e the fir m is c ha rg ing a p r ice of 5 and p r oducin g an output of 100.

If it chos e to r ais e pr ice abo ve 5, itsr ivals would not follow suit and t he fir m

e ff e ctive ly fac e s an e lastic d e mandcu rve for its p r oduct (consum er s wouldbu y f r om t he che ap er r ivals ). The %chan ge in d e mand would b e gre at er than t he % c han ge in p r ice and TR would fall.

Total Reve nu e A

TotalReve nu e B

If the fir m s eek s to low er its p r ice togain a comp e titive ad vanta ge , its r ivalswill follow suit. Any gains it ma ke s willquickly be lost and t he % c han ge inde mand will b e small er than t he %re duction in p r ice total reve nue would a gain fall as t he fir m now fac e sa re lative ly ine lastic d e mand cu rve .

Total Reve nu e B

Total Reve nu e A

The fir m t here fore , e ff e ctive ly fac e s akinke d d e mand cu rve for cing it tomaintain a stabl e or r ig id p r icing st r uctu re . Oligopolistic fi r ms ma y over com e this b y e ngag ing in non -pr ice comp e tition.


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Duopoly Marke t st r uctu re where the indust ry isdominat e d b y two la rge pr oduc er s Collusion ma y be a possibl e f e atu re

Pr ice le ad er s hip b y the la rger of the two fi r ms ma y ex ist the small er fir m follows t he pr ice le ad of t he la rger on e High ly inter de pe nd e nt High ba rr ier s to e nt ry Cou r not Mod e l F re nc h e conomist anal ys e d duopol y

su gge st e d lon g r un eq uilibr ium would s ee eq ual ma rke ts ha re and no r mal p r ofit mad e

In re ality, local duopoli e s ma y ex ist


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Monopoly O rigins of monopoly: Thr ou gh gr owt h of t he fir m

Thr ou gh amal gamation, m erger or ta ke over Thr ou gh ac quir ing pat e nt o r lice ns e Thr ou gh leg al m e ans Royal c ha r ter ,

nationalisation, w holly own e d plc


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Monopoly Summa ry of c ha r act er istics of fi r msexer cisin g monopol y pow er :

P rice could b e dee me d too high , ma y be s e t tode st r oy comp e tition (d e st r oyer or pre dato ry pr icing) , p r ice disc r imination possibl e .

Efficiency could b e ine fficie nt du e to lac k of

comp e tition (X - ine fficie nc y) orcould b e higher du e to a vailabilit y of high pr ofits


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Monopoly Innovation - could b e high be caus e of the pr omis e of high pr ofits, P ossibl y e ncou r a ge s

high inve stm e nt in re s e a r ch and d eve lopm e nt(R&D) C ollusion possibl e to maintain monopol y pow er of key fir ms in indust ry High leve ls of b r andin g, ad ver tisin g and non -pr ice comp e tition


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Monopoly Pr obl e ms wit h mod e ls a re mind er : Oft e n difficult to distin guis h be twee n a monopol y and an

oligopol y bot h ma y exh ibit b eh a viou r that re fle ctsmonopol y pow er

Monopoli e s and oli gopoli e s do not n e ce ssa r ily aim fo r tr aditional assumption of p r ofit ma ximisation

D egree of cont e stabilit y of the ma rke t ma y influe nc e beh a viou r

Monopoli e s not alwa ys bad ma y be de si r abl e in som e cas e s but ma y nee d st r on g reg ulation

Monopoli e s do not ha ve to b e big could ex ist locall y


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Monopoly Costs / Revenue

Output / Sales

AC

MC

ARMR

AR (D) cu rve for a monopolistlike ly to b e re lative ly pr ice ine lastic. Output assum e d tobe at p r ofit ma ximisin g output(not e caution here not allmonopolists ma y aim fo r pr ofit ma ximisation !)

Q1

7.00

3.00

MonopolyProfit

Give n the ba rr ier s to e ntry,the monopolist will b e abl e toex ploit abno r mal p r ofits in t he long r un as e ntry to t he ma rke t is re st r icte d.

Th is is bot h the s hor t r un andlong r un eq uilibr ium positionfor a monopol y


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MonopolyCosts / Revenue

Output / Sales

AC

MC

ARMR

Welfareimplications of monopolies

A look bac k at t he dia gr am fo r per f e ct comp e tition will reve althat in eq uilibr ium, p r ice will be

eq ual to t he MC of p r oduction.We can loo k there fore at acompa r ison of t he diff ere nc e sbe twee n p r ice and output in acomp e titive situation compa re dto a monopol y.

Q1

3

The pr ice in a comp e titive ma rke t would b e 3 wit h output l eve ls at Q1.

Q2

7 The monopol y pr ice would b e 7 p er unit wit h output l eve lslower at Q2.

On t he fac e of it, consum er sfac e higher pr ice s and l e sschoice in monopol y conditionscompa re d to mo re comp e titive e nvir onm e nts.

L oss of consumersurplus

The higher pr ice and low er output m e ans t hat consum er su r plus is re duc e d, indicat e d b y the grey s had e d a re a.


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Output / Sales

AC

MC

ARMR


Q1

3

Q2

7The monopolist will b e aff e cte d b y a loss of p r oduc er su r plus s hown b y the grey

tr ian g le but ..

The monopolist will b e ne fitf r om additional p r oduc er su r plus eq ual to t he grey

s had e d re ctan g le .Gain in producersurplus


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Output / Sales

AC

MC

ARMR


Q1

3

Q2

7The valu e of the grey s had e dtr ian g le re pre s e nts t he totalwe lfare loss to soci e ty som e time s re f erre d to as t he de adw e igh t we lfare loss.


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Contestable MarketsTheory developed by William J. Baumol,John Panzar and Robert Willig (1982)

Helped to fill important gaps in marketstructure theoryPerfectly contestable market thepure form not common in reality but abenchmark to explain firms behaviours


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Contestable MarketsK ey characteristics:

Firms behaviour influenced by the threat of new entrantsto the industry

No barriers to entry or exit No sunk costs Firms may deliberately limit profits made to discourage

new entrants entry limit pricing Firms may attempt to erect artificial barriers to entry

e.g.


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Contestable MarketsOver capacity provides theopportunity to flood the market anddrive down price in the event of a

threat of entryAggressive marketing and brandingstrategies to tighten up the marketPotential for predatory or destroyer

pricingFind ways of reducing costs andincreasing efficiency to gain competitiveadvantage


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Contestable MarketsH it and Run tactics enter theindustry, take the profit and getout quickly (possible because of the freedom of entry and exit)Cream-skimming identifying

parts of the market that are highin value added and exploitingthose markets


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Contestable MarketsExamples of markets exhibitingcontestability characteristics: Financial services Airlines especially flights on

domestic routes Computer industry ISPs, software,

web development Energy supplies The postal service?


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Market StructuresFinal re mind er s:Mode ls can b e us e d as a compa r ison t hey a re not n e ce ssa r ily me antto BE re ality!

Whe n loo king at re al wo r ld ex ampl e s, focus on t he beh a viou r of the fir m in re lation to w hat t he mod e l pre dicts would happ e n t hat give sthe basis fo r anal ysis and ev aluation of t he re al wo r ld situation.Reg ulation o r the thre at of reg ulation ma y we ll aff e ct the wa y a fi r mbeh a ve s.Re me mb er that t he s e mod e ls a re bas e d on c er tain assumptions inthe re al wo r ld som e of the s e assumptions ma y not b e valid, t his allowsus to d r aw compa r isons and cont r asts.The wa y that gover nm e nts d e al wit h fir ms ma y be bas e d on a ge ner alassumption t hat mo re comp e tition is b e tter than l e ss !

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