MICROECO CH6 PERFECT COMPETITION AND MONOPOLY

6.1 Alternative Market StructuresType of market

Number of firms

Freedom of entry

Nature of product

Examples Demand curve

Perfect competition

Very many Unrestricted

Undifferentiated (homogeneous)

Carrots Horizontal, firm is price taker.

Monopolistic competition

Many/several Unrestricted

Differentiated Restaurants Downward sloping, relatively elastic. Firm has some control over price.

Oligopoly Few Restricted Undifferentiated, differentiated

Petrol, cars Downward sloping, inelastic, price change depends on rivals.

Monopoly One Restricted or blocked

Unique Water Downward, inelastic, firm considerable controls price.

6.2 Perfect CompetitionThe model of perfect competition is built on four assumptions:

- Firms are price takers, because there are so many firms, no one has control over price.

- Complete freedom of entry, which applies in the long-run, because it takes time to start a business.

- Because the product is identical, there is no branding or advertising.- Producers and consumers have perfect knowledge of the market.

In the short-run, the number of firms is fixed, and firms can be able to make supernormal profits. However, in the long-run, the number is not fixed. In the long-run, the level of profits affects entry and exit (high profits many new firms, so supply will shift to the right). Therefore, short-run (left) and long-run (right) equilibrium differs.

Perfect Competition is only possible if there are no economies of scale. As there are many firms, most are too small to experience economies of scale. If, however, a firm does experience economies of scale, perfect competition will be destroyed, as that firm then gets market power, and is able to undercut prices.

Firms under perfect competition can only increase profit by becoming more efficient, which also benefits the consumer.

Perfect competition leads to consumer sovereignty: where consumers determine what, and how much is produced.

Why perfect competition benefits society:- Price equals marginal utility, which equals marginal cost. Production levels are just

right. This is an optimal position.- Equilibrium in the long-run is at the bottom of the firm’s LRAC. Therefore the firm will

produce at the least-cost output.- “Survival of the fittest”, this encourages firms to be efficient and invest in technology.- Prices are kept at minimum.- Firms will respond to changing consumer interests.

Limitations of perfect competition:- Production of certain goods can lead to pollution, which perfect competition cannot

safeguard against.- There is no guarantee that goods produced will be distributed to society equally. - Even though there is an incentive to be efficient and develop new technology, long-

run profits may not be sufficient to fund that. Moreover, because there is complete knowledge of the market, rivals could copy them and it would therefore be seen as a waste of money.

- The pressure to innovate and improve products does not exist under perfect competition because the product is homogeneous.

6.3 MonopolyA monopoly exists when there is only one firm in the industry. The amount of monopoly power a firm has depends on the closeness of substitutes and therefore affects elasticity. For example PostNL. They have a monopoly over the delivery of letters, but face competition from e-mail and text messages. For a firm to maintain a monopoly power, there must be barriers to entry:

- Economies of scale: if a monopoly experiences substantial economies of scale, it might not even be able to support more than one firm (natural monopoly). Even if the market could support more than one firm, the established firm, which experiences economies of scale, can set a lower price than the new entrant’s costs, and can and therefore deter them (limit pricing).

- Network economies: when consumers will benefit from using the same service or product (eBay, Marktplaats).

- Economies of scope: when the monopolist experiences lower average cost by producing a range of products.

- Differentiation and brand loyalty: if a firm produces a clearly differentiated product, where the consumer associates the product with the brand, it is hard to break into that market (Coca-Cola).

- Lower cost for established firm: as the established firm is likely to have developed specialised production and is more aware of the most efficient techniques, new firms will have a hard time trying to compete.

- Ownership/control of key inputs: when a firm governs the supply of vital inputs, it can deny access to new entrants.

- Ownership/control of wholesale or retail outlets: a firm can prevent new entrants to have access to consumers (chilled Coca-Cola display).

- Legal: monopoly position can be protected by patents, copyright, licensing, and by tariffs. This can keep out foreign competitors.

A monopolist will maximise profits where MR=MC. A monopolist is likely to make supernormal profits, which will not be competed away in the long-run because there are barriers to entry. Therefore, the only difference between long-run and short-run is that on the long-run, a monopolist maximises profits where MR=LRMC.

Disadvantages of monopoly:- Higher price and lower output than under

perfect competition in short-run and long-run. A monopolist produces where MR=MC, companies under perfect competition, however, produce where S(MC)=D. Moreover, in the long-run, under perfect competition, supernormal profits are eliminated and firms produce at the bottom of their LRAC curve, therefore prices will be kept down. This does not apply to a

monopolist as the supernormal profits are not eliminated.- Higher cost curves due to lack of competition. Under perfect competition, firms will

be forced to be as efficient as possible in order to survive. This incentive does not exist under a monopoly. A monopolist can still make large profits even if it is not using the most efficient technique.

- High profits of monopolists may be considered as unfair.- Lack of incentive to introduce new product varieties.

Advantages of monopoly:- Economies of scale, because a monopolist uses larger plants etc. A monopolist can

therefore produce a higher output at a lower price than firms under perfect competition.

- Lower cost curves due to R&D. Monopolists can use part of their supernormal profits to invest in R&D, it can become very efficient. Something firms under perfect competition are not capable of.

- Threat of takeover (competition for corporate control). If the monopolist is not being efficient, it may face a takeover bid from another company. Therefore it is forced to be efficient.

- Innovation, as the promise of supernormal profits can encourage the monopolist.

6.4 Contestable MarketsThe theory of contestable markets argues that what is crucial in determining price and output is not whether an industry is actually a monopoly or competitive, but whether there is a threat of competition. It argues that the threat of competition has a similar effect to actual competition. A threat of competition can also apply to monopolists!

A perfectly contestable market is when the costs of entry and exit by rivals are zero, and when entry can be made rapidly. When a firm in a certain industry makes supernormal profits (P1), competition will begin and the supernormal profits will be driven down. This will ensure that the firm will keep its prices down (P2), and produces as efficient as possible, in order to deter new entrants.

In a perfectly contestable market, sunk costs (costs that cannot be recouped) are zero. That’s why firms are more willing to take a risk and enter the market, because they know that they can transfer the capital when they are unsuccessful.

One thing a firm can do to deter new entrants, even in a perfect contestable market, is to let any firms who dare to enter know that they will face all-out war.

A monopoly that operates in a perfectly contestable market, it is beneficial for the customers as they will keep prices down.

MICROECO CH7 IMPERFECT COMPETITION7.1 Monopolistic CompetitionMonopolistic competition is a situation where there are a lot of firms competing, but where each firm nevertheless does have some degree of market power.

There are quite a large number of firms, therefore a firm’s actions will not affect the rivals, and the other way around (independence).

Freedom of entry into the industry. Each firm produces a product or service somewhat different from its rivals, therefore

it differs from perfect competition (product differentiation). Relatively elastic demand curve, because there are many substitutes.

Typical in monopolistic competition is local monopoly. There might be a lot of hairdressers In town, but only one in each area. Therefore people are likely to go to the one closest to them, and are prepared to pay higher prices to avoid travelling.

Limitations of monopolistic competition:- Information could be imperfect: firms will not enter the industry because they do not

know that supernormal profits are being made.- It is difficult or impossible to make a demand curve for the industry as a whole,

because of product differentiation.- Firms differ in a lot, also cost structure and size. Therefore some companies can

achieve supernormal profits and other cannot.- The figures only concentrate on price and output decisions.

Compared to perfect competition: Less will be sold at a higher

price. Firms will not be producing at

the least-cost point.

Benefits of monopolistic competition:- Economies of scale can be gained.- Consumers have a great variety of

products to choose from.- Highly elastic demand curve.

Non-price competition involves two major elements: product development and advertising. The aim of product development is to create a product that differs from the rivals’ product and that will sell well. The aim of advertising is to sell the product. These two things not only increase demand and revenue, but also costs. Companies should aim to advertise until MRa=MCa (maximum). However, it is difficult to forecast the effect of development and advertising, and companies will face complex choices.

Equilibrium in short-run (left) and long-run (right):

A firm facing little competition and whose product is clearly differentiated can earn supernormal profits in the short-run (left, shaded area). However, if a firm makes supernormal profits, new firms will enter the industry in the long-run, and demand for the established firm will shift to the left. This will continue to happen until only normal profits are being made (right). At that point, new firms will not enter the market.

7.2 OligopolyAn Oligopoly occurs when just a few firms have a large proportion of the industry.

Barriers to entry: similar to those under monopoly, but depends on the industry. Interdependence: each firm is affected by its rivals’ actions (mutually dependent).

Types of oligopoly:- Collusive oligopoly: when firms agree on output, prices, market share etc. This

reduces uncertainty and increases profits. A formal collusive agreement is called a cartel, when companies act like a monopoly to maximise profits. When agreed on a price, firms can compete for sales or be given a quota. This is called open collusion, which is illegal. Firm can only tacitly collude by watching each other’s prices and keeping theirs similar.

o Dominant firm price leadership: firms choose the same price as that set by a dominant firm in the industry.

o Barometric firm price leadership: firms choose the price as a company which reflects market conditions best sets them.

o Average cost pricing: where a firm sets its price by adding a certain percentage on top of average cost. Very useful in times of inflation.

o Price benchmarks: firms will set a price that is typically used. Prices will be raised from one benchmark to the other (€19.95-€24.95 instead of €19.95-€22.48).

Collusion is likely when firms clearly identify with and trust each other. It will be easier for firms to collude when the following conditions apply:

o They know each other’s costs and production methods.o They have similar production methods and costs.o They produce similar products.o There is a dominant firm.o There are significant barriers to entry, little fear of disruption.o The market is stable.o There are no government measures to curb collusion.

- On the other hand, firms can compete with each other: non-collusive oligopoly:Even if there is a cartel, firms will be tempted to cheat by cutting prices or by selling more than their quota. (figure 7.6 book).Even when firms do not collude, they still have to take account of their rivals’ likely behaviour. There are three ways of doing this:

o Assumptions about given quantity: Cournot model: this model takes the simple case of two firms (duopoly) producing an identical product (figure 7.7).

o Assumptions about price: Bertrand model: this model takes the case of a duopoly but it applies to industries with more firms as well. For example, Firm A believes that price of Firm B is constant, so it will set a price underneath that price to gain market share. Firm B will do the same, so it is an ongoing process until supernormal profits are eliminated.

o Kinked demand curve assumption: this model seeks to explain how it is that, even when there is no collusion at all, prices can nevertheless remain stable.

If an oligopolist cuts its price, its rivals will feel forced to follow suit and cut theirs, to prevent losing customers.

If an oligopolist raises its price, its rivals will not follow suit and will thereby gain customers.

Demand is relatively elastic above the kink. Demand is relatively inelastic below the kink. Check Figure 7.9 for price conditions under kinked demand curve.

Disadvantages Oligopoly:- Same as monopoly, but worse in a sense that:- Less scope for economies of scale.- Oligopolists are likely to engage in much more advertising.

Advantages Oligopoly:- Oligopolists can use part of their supernormal profits for R&D, and they have an incentive to

do so (unlike monopolists).- Greater choice for the consumer because of product differentiation.

7.3 Game TheoryBehaviour of a firm under non-collusive oligopoly will depend on how it thinks its rivals will react to its policies. This is examined in the game theory, where economists look at strategic approaches of firms in-depth. Game theory examines the best strategy for a firm for each assumption about its rivals’ behaviour. There are various types of game theories:

- Single-move game (aka single-period/normal-form game)- Simple dominant-strategy games: many have predictable

outcomes, despite any assumptions each firm makes about the rivals. The assumptions will all lead to the same strategy, therefore it is a dominant-strategy game.

o Cautious approach: think of the worst thing its rival could do (maximin). Taking the example of the picture, the worst thing for person A to happen when he stays

quiet is when person B accuses him. This results in 10 years for person A. If, however, person A accuses person B, the worst outcome is 5 years. Therefore person A will accuse the partner. Considering that person B also thinks like this, they will both end up with 5 years of prison.

o Optimistic approach: assume that the rival will react in the way most favourable to you (maximax). For person A, this is when he accuses person B but person B stays quiet, resulting in 0 years for person A. This applies to person B as well, as he also hopes to get 0 years by accusing the other person. In the end, they will end up with 5 years each by both accusing each other.

The dominant-strategy in this case is 5 years each, as both approaches will lead to this.

Collusion, rather than non-collusion, could have helped in this situation! If the two prisoners were allowed to speak, they would have ended up with 1 year each.

- Complex games: where there are more than two firms, many alternative prices, differentiated products and various forms of non-price competition.

o Maximin approach: if Firm X wants to go safe, it will choose strategy 2 because the worst outcome is a profit of €20, c. Whereas the worst outcomes for 1 and 3 are €15 or -€20.

o Maximax approach: if Firm X wants to go for a high-risk approach, it will choose strategy 1, with a potential of €100, a. Whereas the best outcomes for 2 and 3 are €60, or €90.

o Alternatively, it might go for a compromise strategy and adapt strategy 3. The best outcome for 3 is €90 (slightly lower than 1), and the worst is €15 (slightly lower than 2).

- Multiple-move games: when a firm reacts if the rival does so first, whereas the rival will react again, and the firm will react etc. etc. This is known as repeated or extensive-form games.

o Tit-for-tat: when a second firm will act aggressively only if the first firm makes an initial aggressive move. Otherwise the second firm is willing to cooperate.

Assuming the partners can speak, A would only accuse B if B started to accuse A.

o Decision-tree: a diagram showing the sequence of possible decisions by competitor firms and the outcome of each combination of decisions. See figure 7.10.

An advantage of the Game Theory is that the firm does not need to know what the competitor is going to do. It only needs to know the effect of each possible response. However, that is very important and therefore the Game Theory is only useful in relatively simple cases.

7.4 Price DiscriminationWhen a firm practices price discrimination, it sells the same product to different consumers at different prices even though production costs are the same. There are various types:

- First-degree price discrimination is where the firm charges each consumer the maximum price he or she is prepared to pay for each unit (happens at markets).

- Second-degree price discrimination is where the firm charges customers different prices according to how much they purchase.

- Third-degree price discrimination is where consumers are grouped into independent markets and a separate price is charged in each market.

There are three conditions that must be met in order for price discrimination to work:- The firm must be a price maker; the firm must have some monopoly power.- The markets must be separable. Consumers in low-priced markets must not be able to resell

their product in the high-priced market.- Demand-elasticity must differ in each market; the firm will charge the higher price in the

inelastic market.

Check graphs 7.11-7.14 in the book!

Advantages and disadvantages of price discrimination:- Those paying the higher price will think it is unfair. Their consumer surplus is lower.- Those paying the lower price will have a greater consumer surplus and like it. They are now

able to consumer more of the good they otherwise could not afford. Therefore price discrimination is likely to increase output and make the good available.

- A firm can apply predatory pricing (setting price below AC) to drive its competition out of business, to then raise the price above what the competitors had been charging.

- Price discrimination raises a firm’s profits, which can be used for R&D and lower costs in the future.

MICROECO CH8 ALTERNATIVE THEORIES OF THE FIRM8.1 Problems with traditional theoryThe traditional profit-maximising theories have been criticised for:

- The firms wish to maximise profits but for some reason are unable to do so,- The firms have aims other than profit maximisation.

Difficulties in maximising profit:- Lack of information: difficult to measure true profit. Firms do not know their demand

curves or MR curves. Measuring the demand curve is somewhat impossible as it is hard to estimate the actions and reactions of other firms and their effects.

- Problem of deciding the time period over which the firm should be seeking to maximise profits (investing now means low short-run profits, but possibly high long-run profits).

Firms do not even aim to maximise profits, even if they could. The traditional theory assumes that the owners of the firm make decisions and therefore aim to maximise profits. However, owners do not always make the decisions. In public limited companies, owners are the shareholders, who elect directors, who employ managers, who are given the power to make decisions. There is a separation of ownership and control. Managers want to maximise their own utility, which could conflict with profit maximisation. They still have to ensure that sufficient profits are being made, but this differs from maximising profits.

Alternative theories tend to assume that large firms are profit satisficers (decision makers in a firm aim for a target level of profit rather than the maximum level).

8.2 Behavioural theoriesFirms sometimes deviate from rationality: why they may not always attempt to maximise profits. One reason is that managers are pursuing their own interest, rather than those of their employer. Another reason is that firms operate in complex environments and do not have all the information to act rationally.

Rational behaviour: A decision-making process that is based on making choices that result in the most optimal level of benefit or utility for the individual.

Reasons for not acting in a rational way:- Managers of the firm may have a “history” with other firms. If they have to

collaborate, the manager might feel a desire for revenge, instead of aiming profit-maximising.

- People (principals) have to employ others (agents) to carry out their wishes. Principals do this because agents have specialist knowledge. This relationship can be dangerous for the principal, as there is asymmetric information between the two sides. The agent knows more about the situation that the principal, and therefore may not act in the principal’s best interests, and may be able to get away with it because of the principal’s imperfect knowledge.

Asymmetric information prevents efficient outcomes for firms.

Principal-agent problem: where principals, as a result of lack of knowledge, cannot ensure that their best interests are served by their agents.

Overcoming the principal-agent problem:- The principals must have some way to monitor the agent’s performance (by

employing efficiency experts).- There must be incentives for agents to behave in the principal’s interests (linking

salaries to the firm’s profitability).

In a competitive market, managers’ and shareholders’ interests are more likely to be the same, as managers can lose their job if the company is not working efficiently. However, in monopolies and oligopolies, supernormal profits are easily earned and therefore the interests are likely to be different.

Aiming for profits, sales etc. is useless if a firm does not survive. Therefore, firms are very cautious. However, some are not and are prepared to take risks, which is a characteristic of a successful entrepreneur. However, being too cautious can cause a firm to not survive.

8.3 Alternative maximising theoriesLong-run profit maximisation: an alternative theory which assumes that managers aim to shift cost and revenue curves as to maximise profits over some longer time period. Achieving this is very complex, as the decisions taken today affect tommorow’s demand and cost curves. It could be useful to try to measure the effect of price/output/investment decisions on new entrants, consumer demand, future costs etc.

Managerial utility maximisation: a theory developed by Williamson, who argues that, when satisfactory levels of profit are achieved, managers often have discretion to choose what policies to pursue, and therefore will pursue policies to maximise their own utilities. The factors affecting this are salary (directly measurable), job security, dominance, and professional excellence. Concluding, average costs are higher when managers seek to maximise their own utility.

Sales revenue maximisation (short-run): managers aim to maximise the firm’s short-run total revenue, because the success of managers, especially sales managers, may be judged according to the level of the firm’s sales. Therefore sales maximisation might be more important to a firm than profit maximisation. Sales are maximised at Q1 (top of TR curve), however, profits are maximised at Q2.

Firms are seen as profit satisficers, because they are not seeking the optimal results, but sufficient/adequate results. This is shown in the figure.

Q3 represents sales maximisation. Q1 represents profit maximisation. However, the firm will produce Q2 to achieve the target (horizontal line).

Growth maximisation: managers seek to maximise the growth in sales revenue over time, rather than short-run. This can be achieved by internal expansion or mergers.

- Internal expansion: this requires an increase in sales, which requires an increase in the firm’s productive capacity. In order to increase sales, the firm has to engage in product promotion and launching new products. In order to increase productive capacity, a firm needs new investment. These things require finance, which requires borrowing.

o The more a firm invests, the more the dividends on shares will fall in the short-run, and shareholders are likely to sell their shares unless they are confident that long-run profits will rise again.

o If shareholders sell their shares, the firm faces the risk of being taken over (takeover constraint: the effect that the fear of being taken over has on a firm’s willingness to undertake projects that reduce distributed profits).

- Vertical integration: if growing through sales are difficult, a firm may choose to grow vertically. This has advantages:

o Economies of scale can occur by the business performing complementary stages of production within a single business unit.

o Uncertainty is reduced as a firm is no longer reliable on suppliers etc.o It can give the firm greater power as it can deter new entrants, if a firm owns

a key input resource. However, a firm might get stuck and not be able to respond to

changing markets that quickly.- Diversification: when a firm decides to diversify into other markets so that risks are

spread (Virgin: aircraft, trains, music, mobile phones etc. etc.).

Growth by merger: firms can undertake mergers for growth, because this is quicker than internal expansion, economies of scale, monopoly power, an increase of the shares’ value, and to reduce uncertainty. These reasons can increase profits, which can be used to finance further growth. There are three types of mergers:

- Horizontal merger: firms in the same industry and at the same stage of production merge (two car manufacturers).

- Vertical merger: firms in the same industry but at different stages in the production of a good merge (a car manufacturer and a car producer).

- Conglomerate merger: firms in different industries merge.

Growth through strategic alliances: where two firms work together, to achieve a mutually desirable goal. Firms do this to share risk, and it could be advantageous to a firm to join with an existing player in the market who has more knowledge and a network of suppliers and distributors already. Moreover, costs are shared, which is especially convenient in high-cost projects.

- Joint Venture: two or more firms decide to create and jointly own a new independent organisation.

- Consortia: two or more firms work together on a project and create a separate company to run the project.

- Franchise: formal agreement whereby a company uses another company to produce or sell some or all of its product.

- Subcontracting: where a firm employs another firm to manufacture or supply a service rather than doing it itself.

- Network: where two or more businesses work collaboratively towards a common goal, but without any formal binding relationship.

8.4 Multiple aimsBecause large firms are often complex with many departments, each department is likely to have its own specific set of aims and objectives, which can conflict with those of other departments. Often, targets are set for department, and if they are not achieved, a search procedure will be started to find out the problem and how to solve it. Sometimes, targets have to be adjust downwards or upwards, so the targets always depend on the previous results.

Business conditions change rapidly, however, changing targets is something managers want to avoid (as it costs time and money). Therefore, managers will tend to keep targets low and allow slack to develop, so targets are easily met (organisational slack).

- Some firms overcame this by using just-in-time methods of production: keeping stocks to minimum and ensuring that inputs are delivered as required. This requires reliable suppliers and tightly controlled production.

8.5 Pricing in practice Because firms do not have all the information (MC, MR curves) to set the price where MC=MR, it will apply other methods:

- Cost-based pricing (average cost or mark-up pricing): price is set by adding a profit mark-up to average cost. P=AFC + AVC + profit mark-up. The amount of this mark-up depends on the firm’s aims, and the actions/responses of rivals.

o if a firm can estimate the demand curve, it can set its output and mark-up at levels which will avoid shortages or surpluses (figure 8.3 book).

o If a firm cannot estimate the demand curve, it could just adjust its mark-up and output over time by a process of trial and error.