Revision:Revision:competition, monopoly, competition, monopoly,

oligopoly oligopoly

Unit 03Unit 03

A market is in perfect competition if every buyer and every seller is so A market is in perfect competition if every buyer and every seller is so small that he or she cannot influence prices…small that he or she cannot influence prices…

… … and if goods are perfectly substitutes.and if goods are perfectly substitutes.

If the price is given and invariable…If the price is given and invariable…

1.1. The total revenue increases as quantities increaseThe total revenue increases as quantities increase

2.2. The average revenue remains invariableThe average revenue remains invariable

3.3. The marginal revenue is invariable and equal to price.The marginal revenue is invariable and equal to price.

Goal of the firmGoal of the firm: maximising profits: maximising profits

The profit is maximum when marginal revenue = marginal costThe profit is maximum when marginal revenue = marginal cost

Profits and losses: how to Profits and losses: how to measure themmeasure them

Profit = total revenue – total costProfit = total revenue – total cost

((RT –CTRT –CT ) )

or: average revenue – average cost or: average revenue – average cost times the quantitytimes the quantity

( ( (RMe – CMeT) (RMe – CMeT) Q Q ) ) P = RmeP = Rme( ( (P – CMeT) (P – CMeT) Q Q ))

Conversely:Conversely:

Loss = average cost – price times Loss = average cost – price times the quantitythe quantity

( ( (CMeT – P) (CMeT – P) Q Q ) )

The quantity Q, respectively, The quantity Q, respectively, maximises profit or minimises loss.maximises profit or minimises loss.

In the long runIn the long run: :

- entry: when price is higher than average total cost- entry: when price is higher than average total cost

( ( PP > > CMeTCMeT ) )

- exit: when price is lower than average total cost- exit: when price is lower than average total cost

( ( PP < < CMeTCMeT ) )

The firm decides The firm decides to enter the market to enter the market only if revenues only if revenues cover all costs, cover all costs, including fixed including fixed onesones

- equilibrium: when price = average total cost - equilibrium: when price = average total cost

( ( PP = = CMeTCMeT ) )

In the long run In the long run profits are equal to profits are equal to zerozero

P

Fundamental cause of monopoly: Fundamental cause of monopoly: entryentry barriersbarriers

Entry barriers have three causes:Entry barriers have three causes:

1.1. A key resource is possessed by a single firm: A key resource is possessed by a single firm: resourceresource monopolymonopoly

2.2. States grant to a single firm the exclusive right to produce a good States grant to a single firm the exclusive right to produce a good (patents, privatives): (patents, privatives): legallegal monopolymonopoly

3.3. The structure of production costs makes a single firm more The structure of production costs makes a single firm more efficient than a multitude of small producers: efficient than a multitude of small producers: naturalnatural monopolymonopoly

Natural monopolyNatural monopoly: the average total cost curve continuously : the average total cost curve continuously decreases instead of having the usual U-form.decreases instead of having the usual U-form.

If production were divided among many firms, each of them could If production were divided among many firms, each of them could produce a lesser quantity at higher average total costs.produce a lesser quantity at higher average total costs.

CasesCases

- water distributionwater distribution

- railway networkrailway network

A fundamental characteristic of a monopoly firm is its capacity to A fundamental characteristic of a monopoly firm is its capacity to influence market prices. Under perfect competition the price is given.influence market prices. Under perfect competition the price is given.

The demand curve of a competitive firm corresponds to a infinitesimal The demand curve of a competitive firm corresponds to a infinitesimal share of the market and is perfectly elastic. That of the monopoly firm share of the market and is perfectly elastic. That of the monopoly firm coincides with the demand curve of the whole market and is normally coincides with the demand curve of the whole market and is normally downwards sloping.downwards sloping.

The demand curve (The demand curve (reflecting buyers’ willingness to payreflecting buyers’ willingness to pay) represents ) represents the only constraint to the monopolist’s market power.the only constraint to the monopolist’s market power.

If the monopolist increases the price of his/her good, consumers buy a If the monopolist increases the price of his/her good, consumers buy a lower quantity and vice versa if he or she diminishes the price.lower quantity and vice versa if he or she diminishes the price.

Total, average and marginal revenues of a Total, average and marginal revenues of a monopolistmonopolist

QuantityQuantity PricePrice Total Total revenuerevenue

Average Average revenuerevenue

Marginal Marginal revenuerevenue

QQ PP RT = P RT = P Q Q RMe = RT/QRMe = RT/Q RM=RM=RT/ RT/ QQ

00 1111 00 --

11 1010 1010 1010 1010

22 99 1818 99 88

33 88 2424 88 66

44 77 2828 77 44

55 66 3030 66 22

66 55 3030 55 00

77 44 2828 44 -2-2

88 33 2424 33 -4-4

Graphically:Graphically:

Average revenue = PriceAverage revenue = PriceMarginal revenue: always lower than average revenueMarginal revenue: always lower than average revenue

Gola of the monopolisty firm is always profit maximisation. Gola of the monopolisty firm is always profit maximisation.

The usual condition is: The usual condition is: RM = CMRM = CM..

NB:NB:

P > RMP > RM

Under Under competition, competition, on the on the contrary:contrary:

P = RMP = RM

The monopolist’s profit is always The monopolist’s profit is always RT – CTRT – CT or or P – CMeT P – CMeT Q Q..

The demand curve reflects The demand curve reflects willingness to paywillingness to pay

The monopolist’s marginal The monopolist’s marginal cost curve reflects his/her cost curve reflects his/her costs.costs.

The socially efficient The socially efficient quantity corresponds to the quantity corresponds to the intersection between the intersection between the marginal cost curve and the marginal cost curve and the demand curvedemand curve

Do monopolies diminish social welfare?Do monopolies diminish social welfare?

Economists answer in the affirmative: monopolies entail a deadweight Economists answer in the affirmative: monopolies entail a deadweight loss for consumers.loss for consumers.

As the monopoly firm maximises profits when As the monopoly firm maximises profits when RM = CMRM = CM, it produces a , it produces a lower quantity than the socially efficient one.lower quantity than the socially efficient one.

Observe the triangle above the price line: it is the consumer surplus when the price is unique.

The triangles A and B represent the deadweight loss. A is the consumer’s loss of surplus, and B is the producer’s loss of surplus (more than compensated by the monopoly profits represented by the rectangle C)

C AB

Let us suppose that the monopolist manages to apply different prices to different groups of customers: small purchases, normal purchases, Large purchases: price discrimination

Effect 1. The surplus of small buyers is reduced, the monopolist’s Profit increases

Let us suppose that the monopolist manages to apply different prices to different groups of customers: small purchases, normal purchases, Large purchases: price discrimination

Effect 2. Buyers that formerly renounced to buy large quantitiesNow decide to buy them. The deadweight loss is diminishedThe monopolist’s profits increase. Social welfare increases!

Limit case: if the monopolist manages to invent a continuous series of classes on which to apply price discrimination, we attain a total elimination of the consumer surplus and of deadwieght loss and the monopolist transforms into profit the whole area above the Average cost curve and below the demand curve.

Perfect price discrimination

NB. Social welfare is maximum!!!

An oligopoly market is a market in which there are a few firms, each An oligopoly market is a market in which there are a few firms, each exerting, by its choices, a considerable influence on the profits of other exerting, by its choices, a considerable influence on the profits of other firms.firms.

Oligopoly is a kind of imperfect competition, in which a few firms sell Oligopoly is a kind of imperfect competition, in which a few firms sell similar products (oil, tennis balls)similar products (oil, tennis balls)

It is different from monopoly competition, in which many firms sell It is different from monopoly competition, in which many firms sell similar although non identical products (CDs, videogames).similar although non identical products (CDs, videogames).

If oligopoly firms cooperate, they act like a monopoly firm and share If oligopoly firms cooperate, they act like a monopoly firm and share profits. profits.

Very often, however oligopoly firms are forced to compete among Very often, however oligopoly firms are forced to compete among them. In this case they adopt a them. In this case they adopt a strategic behaviourstrategic behaviour: they make their : they make their choice according to the choices of competitors, in order to increase their choice according to the choices of competitors, in order to increase their share of the market.share of the market.

But this generates negative effects for all competitors (reduction of But this generates negative effects for all competitors (reduction of profits).profits).

The “game theory” studies the strategic behaviour of oligopoly firms.The “game theory” studies the strategic behaviour of oligopoly firms.

Example of “non cooperative game”: Example of “non cooperative game”: prisoner’sprisoner’s dilemmadilemma..

Let us suppose that Bonnie e Clyde are arrested. Let us suppose that Bonnie e Clyde are arrested. At the moment of arrest they have on them illegal arms. The At the moment of arrest they have on them illegal arms. The punishment for this crime is punishment for this crime is 11 year of imprisonment. year of imprisonment. They are interrogated in different rooms at the same time.They are interrogated in different rooms at the same time.The magistrate proposes to each of them the same deal: if he or she The magistrate proposes to each of them the same deal: if he or she confesses and denounces her or his accomplice, the illegal confesses and denounces her or his accomplice, the illegal possession of firearms will be remitted and he or she will be possession of firearms will be remitted and he or she will be liberated. The accomplice will be condemned to liberated. The accomplice will be condemned to 2020 years of years of imprisonment. If both confess, the punishment will be imprisonment. If both confess, the punishment will be 88 years years (partial remittance for confessing).(partial remittance for confessing).

The following is the “matrix of payoffs”:The following is the “matrix of payoffs”:

The strategy consisting in confessing is called “dominant strategy”. It is The strategy consisting in confessing is called “dominant strategy”. It is advantageous for both, ignoring the choice of the accomplice. If they advantageous for both, ignoring the choice of the accomplice. If they could communicate, the would cooperate and choose not to confess..could communicate, the would cooperate and choose not to confess..

Clyde’s decisions

Bonnie’s decisions

Confess Not to confess

Confess8 years : 8 years liberated : 20 years

Not to confess

20 years : liberated 1 year : 1 year

This example shows that oligopoly companies have an interest in This example shows that oligopoly companies have an interest in making secret (“trusts”) or explicit (“cartels”) agreements, in order to making secret (“trusts”) or explicit (“cartels”) agreements, in order to cooperate and keep high profits. An example is OPEC.cooperate and keep high profits. An example is OPEC.

Another example: oil producing countries:

Saudi Arabia’s decisions

Iran’s decisions

High production Low production

High production 40 billion € : 40 billion € 60 billion € : 30 billion €

Low production

30 billion € : 60 billion € 50 billion € : 50 billion €