Competitive Markets

1
Competitive Markets

• Chapter 23

2
Market Structure
3
Characteristics of Market Structures
4
The Market Supply Curve

• Whatever determines marginal cost also determines
  the competitive firms supply response.
• The price of factor inputs.
• Technology.
• Expectations.
• Taxes.
• The number of firms in the industry.

5
Entry and Exit

• Investment decisions (build, buy, or lease) shift
  the market supply curve to the right.
• Profit motive drives investment decisions.
• If there are economic profits, more firms will
  enter the industry increasing market supply.
• Each firm will respond to the resulting lower
  price and profits by reducing output.

6
Market Entry
Market entry pushes price down and . . .
Reduces profits of competitive firm
S1
MC
S2
ATC
E1
f1
p1
p1
f1
Economic Profit
p2
p2
E2
Market demand
New firms enter
q1
q2
7
Market Characteristics - Perfect Competition

• Some of the structures, behaviors, and outcomes
  of a competitive market are
• Low barriers to entry - entry barriers are low,
  economic profits will attract more firms.

8
Low Barriers to Entry

• Barriers to entry may include

• Patents.
• Control of essential factors of production.
• Control of distribution outlets.
• Well-established brand loyalty.
• Government regulation.

9
Market Characteristics - Perfect Competition

• Some of the structures, behaviors, and outcomes
  of a competitive market are
• Low barriers to entry - entry barriers are low,
  economic profits will attract more firms.
• Many firms - none of which has a significant
  share of total output.
• Identical products - products are homogeneous
  one firms products is the same as any others.
• Perfect information - buyers and sellers have
  complete information on supply, demand, and
  prices.
• MC p - all competitive firms seek to expand
  output until marginal cost equals the products
  market price.
• Zero economic profit - market supply expands as
  long as there are economic profits, pushing
  prices and economic profits down.

10
Tendency Toward Zero Profits

• An increase in market supply causes the economic
  profits to disappear.
• As long as it is easy for existing producers to
  expand production or for new firms to enter an
  industry, economic profits will not last long.
• When economic profits disappear, entry ceases and
  the market price stabilizes.

11
Competition at Work Microcomputers

• Few, if any, product markets are perfectly
  competitive.
• Many industries function much like a competitive
  market.
• The microcomputer market illustrates how the
  process of competition works.

12
Initial Equilibrium Computer Market
13
A Shift of Market Supply

• In competitive markets, economic profits attract
  new entrants.
• The entry of new firms shifts the market supply
  curve to the right.
• New entrants will continue to enter as long as
  there are economic profits in short-run
  competitive equilibrium.

• Short-run equilibrium p MC

14
A Shift of Market Supply

• As supply increases, price drops toward the
  minimum of ATC.
• In long-run equilibrium, entry and exit cease,
  and zero economic profit (that is, normal profit)
  prevails.

• Long-run equilibrium p MC minimum ATC

15
A Shift of Market Supply

• Once established, long-run equilibrium will
  continue until market demand shifts or
  technological improvement reduces the cost of
  computer production.

16
The Competitive Price and Profit Squeeze
An expanded market supply . . .
Lowers price and profits for the typical firm
MC
S1
ATC
S2
Old price
G
New price
H
Market demand
17
The Competitive Squeeze Approaching Its Limit
The computer industry
The typical firm
MC
ATC
S2
S3
Old price
J
700
620
New price
K
Profits
Market demand
18
Short- vs. Long-Run Equilibrium
19
Long-Run Rules for Entry and Exit
20
Allocative Efficiency

• The Right Output Mix
• The amount consumers are willing to pay for a
  good (its price) equals its opportunity cost
  (marginal cost).
• Economic profits in a particular industry
  indicate consumers want a different mix of
  output.

21
Production Efficiency

• Production efficiency means that we are producing
  at minimum average total cost. So technical
  efficiency is achieved where maximum output of a
  good is obtained from the resources used to
  produce it.

22
Competitive Markets Provide Allocative and
Production Efficiency

• When competitive pressure on prices is carried to
  the limit
• society is getting the mix of output it most
  desires, and
• the products in question are produced at the
  least possible cost.

23
Competitive Industry

• High prices and profits signal consumers demand
  for more output.
• The high profits attract new suppliers.
• Production and supplies expand.
• Prices slide down the market demand curve and a
  new equilibrium is established.
• Price equals marginal cost at all times.
• Throughout the process, there is great pressure
  to reduce costs or improve product quality.

24
Summary of Competitive Process
Market demand
Industry ATC
Industry MC
a
c
b
Long-run equilibrium
25
Monopoly

• Chapter 24

26
Market Structure
27
Characteristics of Market Structures
28
Firm vs. Industry DemandPerfect Competition
13
13
Market demand
Competitive firms face a horizontal demand curve.
No market power.
29
Firm vs. Industry DemandMonopoly
13
13
Market demand
30
Monopoly

• The demand curve facing the monopoly firm is
  identical to the market demand curve for the
  product.
• Monopoly is a firm that produces the entire
  market supply of a particular good or service.

31
Price and Marginal Revenue

• A monopoly faces a different profit maximizing
  situation than competitive firms. But still at MR
  MC.
• Unlike competitive firms, marginal revenue for a
  monopolist is not equal to price.
• Firms downward-sloping demand curve means MR
  will always be less than price.

32
Price and Marginal Revenue
33
Price and Marginal Revenue
14
12
10
8
Price (per beshel)
Demand ( price)
6
4
Marginal revenue
2
0
1
2
3
4
5
6
7
8
9
10
Quantity (bushels per hour)
34
The Production Decision

• Like any producer, a monopolist wants to produce
  at the rate that maximizes profits.
• Intersection of the marginal revenue and marginal
  cost curves. MRMC

35
Profit Maximization
14
13
12
11
10
9
Monopoly Profits
8
Price or Cost (per bushel)
7
d
6
5
4
3
2
1
0
1
2
3
4
5
6
7
8
9
Quantity (bushel per hour)
36
Monopoly Profits

• A monopoly receives larger profits than a
  comparable competitive industry by reducing the
  quantity supplied and pushing prices up.

37
Barriers to Entry

• Patents offers a producer 20 years of exclusive
  rights to produce a particular product.
• Economies of scale a monopoly may persist
  because of cost advantages over smaller firms
• Monopoly franchises governments create and
  maintain monopolies by giving a single firm the
  exclusive right to supply a particular good or
  service.
• Control of key inputs a company may lock out
  competition by securing exclusive access to key
  inputs.
• Lawsuits may be used to prevent new companies
  from successfully entering an industry.
• Acquisition when all else fails, purchase a
  potential competitor

38
Barriers to Entry

• High barriers to entry prevent profit-hungry
  entrepreneurs from entering the market to compete
  monopoly profits away.
• Monopoly profits persist as long as barriers to
  entry prevent competitors from entering the
  market.
• The preservation of monopoly power depends on
  keeping potential competitors out of the market.

39
The Production Decision

• A firm faces a production decision concerning its
  many plants.
• A monopolist can foresee the impact of increased
  production on market price so it prevents
  production increase by coordinating the
  production decisions of its plants.

40
Monopoly Profits
Monopolist's equilibrium
MC
Competitive short-run equilibrium
A
1100
R
ATC
X
1000
Competitive long-run equilibrium
T
V
U
Market demand
MR
qM
qC
41
Competitive Industry

• High prices and profits signal consumers demand
  for more output.
• The high profits attract new suppliers.
• Production and supplies expand.
• Prices slide down the market demand curve and a
  new equilibrium is established.
• Price equals marginal cost at all times.
• Throughout the process, there is great pressure
  to reduce costs or improve product quality.

42
Monopoly Industry

• High prices and profits signal consumers demand
  for more output.
• Barriers to entry exist or are erected to exclude
  potential competition.
• Production and supplies are constrained.
• Prices do not move down the market demand curve.
  No new equilibrium.
• Price exceeds marginal cost at all times.
• There is no squeeze on profits and thus no
  pressure to reduce costs or improve product
  quality.

43
Monopoly Industry

• Because monopoly markets do not tend towards
  marginal cost pricing (PMC), consumers do not
  get the mix of output that delivers the most
  utility from available resources.
• No allocative or technical efficiency.
• A firm with considerable market power is likely
  to have significant political power as well.

44
The Limits to Power

• Monopolists only have absolute control of the
  quantity of output supplied to the market.
• Monopolists must still contend with the market
  demand curve.
• The greater the price elasticity of demand, the
  more a monopolist will be frustrated in its
  attempts to establish both high prices and high
  volume.

45
Price Discrimination

• A monopolist may be able to extract greater
  profits by practicing price discrimination.
• Price discrimination is the sale of an identical
  good at different prices to different consumers
  by a single seller.

46
Pros of Market Power

• It is conceivable that monopolies could benefit
  society.
• RD
• Reward entrepreneurial activity and innovation
• Develop economy of scale
• Natural monopoly

47
Contestable Markets

• A contestable market is an imperfectly
  competitive market subject to potential entry if
  prices or profits increase.
• Contestable markets are characterized by moderate
  barriers to entry.
• When potential profits reach a certain level
  competitors are enticed to enter the market.

48
Structure vs. Behavior

• The structure of monopoly is, in itself, not a
  problem.
• If potential rivals force a monopolist to behave
  like a competitive firm, then a monopoly imposes
  no cost on consumers or on society at large.
• Anti-trust laws and the EU Competition Commission

49
Antitrust Enforcement

• Government intervention designed to alter market
  structure or prevent abuse of market power.
• Market power contributes to market failure when
  it leads to resource misallocations or greater
  inequity.
• Market failure is an imperfection in the market
  mechanism that prevents optimal outcomes.

50
Oligopoly

• Chapter 25

51
Market Structure
52
Characteristics of Market Structures
53
Determinants of Market Power

• The determinants of market power include
• Number of producers.
• Size of each firm.
• Barriers to entry and contestable markets
• Availability of substitute goods.
• Market power increases
• The fewer the number of firms in the market.
• The larger the relative size of the firms in the
  market.
• The higher the entry barriers.
• The fewer the substitutes.

54
Measuring Market Power

• The standard measure of market power is the
  concentration ratio.
• The concentration ratio is a measure of market
  power that relates the size of firms to the size
  of the market.
• proportion of total industry output produced by
  the largest firms (usually the four largest).
• Concentration ratios do not convey the extent to
  which market power may be concentrated in a local
  market.
• Many smaller firms acting in unison can achieve
  market power.

55
The Herfindahl-Hirshman Index

• The Herfindahl-Hirshman index (HHI) is a measure
  of industry concentration that accounts for
  number of firms and size of each.
• The Herfindahl-Hirshman Index of market equals
  the sum of the squares of the market shares of
  each firm in an industry.

56
The Battle for Market Shares

• In an oligopoly, increased sales on the part of
  one firm will be noticed immediately by the other
  firms.
• Increases in the market share of one oligopolist
  necessarily reduce the shares of the remaining
  oligopolists.

57
Retaliation

• Oligopolists respond to aggressive marketing by
  competitors by
• Cut prices on their product(s).
• Lowering price may expand total market sales and
  increase the sales of an individual firm without
  affecting the sales of its competitors.
• However, cutting prices will lead to a general
  reduction in the market price.
• There simply is no way that a firm can do so
  without causing alarms to go off in the industry
  so oligopolists avoid price competition and
  instead pursue non-price competition..
• Step up marketing efforts.
• Product differentiation Features that make one
  product appear different from competing products
  in the same market.

58
Rivalry for Market Shares
59
Rivals Response to Price Reductions

• The degree to which sales increase when the price
  is reduced depends on the response of rival
  oligopolists.
• We expect oligopolists to match any price
  reductions by rival oligopolists.
• Rival oligopolists may not match price increases
  in order to gain market share.

60
The Kinked Demand Curve Confronting an Oligopolist

• Close interdependence and the limitations it
  imposes on price and output decisions is a
  characteristic of oligopoly.
• The shape of the demand curve facing an
  oligopolist depends on how its rivals responded
  to a change in the price of its own output.
• The demand curve will be kinked if rival
  oligopolists match price reductions but not price
  increases.

61
The Kinked Demand Curve Confronting an Oligopolist
Demand curve facing oligopolist if rivals match
price changes
Elastic due to substitutes
M
B
1100
A
D
900
C
Demand curve facing oligopolist if rivals match
price cuts but not price hikes
Demand curve facing oligopolist if rivals don't
match price changes
8000
The kinked demand curve is really a composite of
two separate demand curves.
62
An Oligopolists MR Curve
The kink in the demand curve
S
A
Price (dollars per computer)
d1
The MR gap
d2
0
8000
Quantity Demanded (computers per month)
There is a gap in an oligopolists marginal
revenue (MR) curve that leads to sticky prices.
63
The Cost Cushion
64
Game Theory

• Each oligopolist has to consider the potential
  responses of rivals when formulating price or
  output strategies.
• The payoff to an oligopolists price cut depends
  on how its rivals respond.

65
Game Theory

• Each oligopolist is uncertain about its rivals
  behavior.

• The collective interests of the oligopoly are
  protected if no one cuts the market price.
• But an individual oligopolist could lose if it
  holds the line on price when rivals reduce price.

66
Oligopoly Payoff Matrix
67
Oligopoly Payoff Matrix
68
The Payoff Matrix

• The decision to initiate a price cut requires a
  risk assessment.

69
Oligopoly vs. Competition

• Oligopolists may try to coordinate their behavior
  in a way that maximizes industry profits.
• An oligopoly will want to behave like a monopoly,
  choosing a rate of industry output that maximizes
  total industry profit.
• To maximize industry profit, the firms in an
  oligopoly must agree on a monopoly price and
  agree to maintain it by limiting production and
  allocating market shares.

70
Maximizing Oligopoly Profits
Like all producers, oligopolists want to maximize
profits by producing where MR MC.
Industry MC
Industry ATC
Profit- maximizing price
Market demand
Economic Profits
Average cost at profit- maximizing output
J
Industry MR
Profit-maximizing output


71
Coordination Problems

• There is an inherent conflict in the joint and
  individual interests of oligopolists.
• Each oligopolist wants industry profits to be
  maximized.
• Each oligopolist wants to maximize its own market
  share.
• To avoid self-destructive behavior, each
  oligopolist must coordinate production decisions
  so that
• Industry output and price are maintained at
  profit-maximizing levels.
• Each oligopolistic firm is content with its
  market share

72
Price Fixing

• The most explicit form of coordination among
  oligopolists is called price fixing with an
  explicit agreement among producers regarding the
  price(s) at which a good is to be sold.
• Cartel

73
Price Leadership

• Price leadership is an oligopolistic pricing
  pattern that allows one firm to establish the
  market price for all firms in the industry.

74
Allocation of Market Shares

• An oligopolist may resort to predatory pricing
  when market shares are not being divided in a
  satisfactory manner.

• Predatory pricing - temporary price reductions
  designed to alter market shares or drive out
  competition.

75
Nonprice Competition

• Advertising not only strengthens brand loyalty,
  but also makes it expensive for new producers to
  enter the market.
• Early market entry can create an important
  barrier to later competition.
• Customers of training-intensive products (such as
  computer hardware and software) become familiar
  with a particular system.
• The widespread use of a particular product may
  heighten its value to consumers, thereby making
  potential substitutes less viable.

76
Monopolistic Competition

• Chapter 26

77
Market Structure
78
Characteristics of Market Structures
79
Characteristics

• Low concentration ratios are common in
  monopolistic competition.
• Each producer in monopolistic competition is
  large enough to have some market power.
• A monopolistically competitive firm confronts a
  downward-sloping demand curve for its output.
• Modest changes in the output or price of any
  single firm will have no perceptible influence on
  the sales of any other firm.
• No worry about retaliatory responses to every
  price or output change.
• Presence of low barriers to entry.

80
Brand Image Loyalty Product Differentiation

• Each firm has a distinct identity a brand image
  where each firm has a monopoly only on its brand
  image.
• Consumers perceive its output to be somewhat
  different than others in the industry.
• By differentiating their products, monopolistic
  competitors establish brand loyalty.
• Brand loyalty gives producers greater control
  over the price of their products.
• It still competes with other firms offering close
  substitutes.
• Brand loyalty makes the demand curve facing the
  firm less price-elastic.

81
Entry and Exit

• With low barriers to entry, new firms will enter
  the market if there is economic profit.
• When firms enter a monopolistically competitive
  industry
• The market supply curve shifts to the right.
• The demand curves facing individual firms shift
  to the left.
• In the long run, there are no economic profits in
  monopolistic competition.

82
Effects of Entry on Industry and Firm
Reduced market share
p1
p2
Later demand facing film
MR
83
Equilibrium in Monopolistic Competition
The profit-maximizing rate of output is achieved
by producing the quantity where MR MC.
84
Consequences

• Inefficiency
• Monopolistic competition tends to be less
  efficient in the long run than a perfectly
  competitive industry.
• Excess Capacity
• Because of the industry-wide excess capacity,
  each firm produces a rate of output that is less
  than its minimum ATC.
• Flawed Price Signals
• The monopolistically competitive firm will always
  price its output above the level of marginal
  cost.
• Monopolistic competition results in both
  production inefficiency (above-minimum average
  cost) and allocative inefficiency (wrong mix of
  output).

85
No Cease-Fire in Advertising Wars

• In truly (perfectly) competitive industries,
  firms compete on the basis of price.
• Imperfectly competitive firms engage in nonprice
  competition the most prominent form being
  advertising.