Chapter 6: Market Structure

1
Chapter 6 Market Structure

• Brickley, Smith, and Zimmerman, Managerial
  Economics and Organizational Architecture, 4th
  ed.

2
Market structureobjectives

• Students should be able to
• Differentiate among the four archetypal market
  structures
• Distinguish between price takers and price
  searchers

3
Market Structure

• Last week we analyzed production and costs
  decisions and how costs influence a managers
  decision on what inputs to use and how much to
  produce.
• This week we look at how market structures
  influence a managers decision on how much to
  produce, what price to charge and how to maximize
  profitability under different market structures

4
Market Structure

• Please read The Market for Cable Television case
  study, pages 160-161
• The example of cable TV illustrates how policy
  choices-such as pricing, product design, and
  advertising-are influenced critically by the
  market environment.
• Policies that work within a protected market
  environment often have to be amended radically
  when facing a more competitive environment.

5
Market Structure

• It is important that managers understand the
  firms market environment and how this set of
  market circumstances affects decision making.
• Our purpose in this chapter is to enhance that
  understanding by exploring the implications of
  alternative market structures.

6
Market Structure

• Our primary focus is on output and pricing
  decisions within different market structures.
• We begin by discussing markets and market
  structures in greater detail.
• Then pricing and output decisions within
  different market structures

7
Markets

• A market consists of all firms and individuals
  who are willing and able to buy or sell a
  particular product.
• These parties include those currently engaged in
  buying and selling the product, as well as
  potential entrants.
• A market is a process that facilitates trade
  rather than a place and where prices and quantity
  bought and sold are discovered through
  interaction of buyers and sellers

8
Market Strucute

• Market structure refers to the basic
  characteristics of the market environment,
  including (1) the number and size of buyers,
  sellers, and potential entrants (2) the degree
  of product differentiation (3) the amount and
  cost of information about product price and
  quality and (4) the conditions for entry and
  exit.

9
Characteristics of the Four Major Market
Structures
10
Four Market Models

• Pure Competition
• Pure Monopoly
• Monopolistic Competition
• Oligopoly

Imperfect Competition
Pure Competition
Monopolistic Competition
Pure Monopoly
Oligopoly
Market Structure Continuum
11
Perfect competitioncharacteristics

• Many buyers and sellers
• Product homogeneity (standardized products)
• Low cost and accurate information
• Free entry and exit
• The firm is a price taker
• Best regarded as a benchmark to compare other
  market structures and their efficiencies

12
4 Major Objectives of Analysis

• To examine demand from a sellers viewpoint
  (including pricing and output decisions)
• To see how a competitive producer responds to
  market price in the short-run
• To explore the nature of long-run adjustments
• To evaluate the efficiency of competitive
  industries

13
Perfect competitioncharacteristics

• In competitive markets, individual buyers and
  sellers take the market price of the product as
  given
• They have no control over price.
• Firms thus view their demand curves as horizontal
  at that given market price

14
Firm demand curveperfect competition Figure 6.1,
page 163
15
Market and Individual Firm Demand Curves in a
Perfectly Competitive Market
16
Revenues for a Perfectly Competitive Firm
17
Market Prices and the Position of a Firms
Demand Curve
18
MR MC Production Rule

• Every company should
• Continue to produce more as long as MRgtMC
• Stop at a production level where MR MC
• Cut back production when MRltMC

19
Finding the Profit-Maximizing Level of Output
20
Short-Term Production Rules

• Economic Profit - When the price is above ATC
  (produce)
• Normal Profit When the price is equal to ATC
  (produce)
• Reduce Losses When the price is below ATC but
  above AVC (continue production)
• Shut Down Point When the price is below AVC.
  Your losses will be equal to fixed costs (stop
  production)

21
Profit Maximization in the Short Run

• Marginal Revenue-Marginal Cost Approach ( MR MC
  Rule)

MR MC
P131
MC
Economic Profit
MR P
ATC
AVC
A97.78
22
Profit Maximization in the Short Run

• Marginal Revenue-Marginal Cost Approach
• MR MC Rule

Loss Minimizing Case
Lower the Price to 81 and Observe the Results!
MC
Loss
A91.67
ATC
AVC
MR P
P81
V 75
23
Profit Maximization in the Short Run

• Marginal Revenue-Marginal Cost Approach
• MR MC Rule

Short-Run Shut Down Case
Lower the Price Further to 71 and Observe the
Results!
MC
ATC
V 74
AVC
MR P
P71
Short-Run Shut Down Point P lt Minimum AVC 71 lt
74
24
Short-Run Profits, Losses, and Zero Economic
Profits
25
Firm Supply

• Why the marginal-cost curve and supply curve of
  competitive firms are identical
• The firm's short run supply curve is that portion
  of its short-run marginal cost curve above
  short-run average variable cost.
• The long-run supply curve is that portion of its
  long-run marginal cost curve above long-run
  average cost.

26
Marginal Cost and Short-Run Supply

• Generalizing the MRMC Relationship and its Use

MC
e
P5
MR5
d
ATC
P4
MR4
c
AVC
P3
MR3
b
P2
MR2
a
P1
MR1
This Price is Below AVC And Will Not Be Produced
Q2
Q3
Q4
Q5
0
27
Marginal Cost and Short-Run Supply

• Generalizing the MRMC Relationship and its Use

Examine the MC for the Competitive Firm
MC Above AVC Becomes the Short-Run Supply Curve
S
Break-even (Normal Profit) Point
MC
e
P5
MR5
d
ATC
P4
MR4
c
AVC
P3
MR3
b
P2
MR2
a
P1
MR1
Shut-Down Point (If P is Below)
This Price is Below AVC And Will Not Be Produced
Q2
Q3
Q4
Q5
0
28
Learning Objectives

• How industry entry and exit produce economic
  efficiency P ATC in the long run and production
  takes place where MR MC
• What is long run competitive equilibrium and why
  companies only make normal profit
• How short-run economic profits will disappear
  with entry of other firms
• How short-run economic losses will disappear with
  exit of some firms

29
Pure Competition and Efficiency

• Productive Efficiency requires that goods be
  produced in the least costly way. In the long
  run, pure competition forces firms to produce at
  the minimum ATC.
• P Minimum ATC
• Allocative Efficiency requires that resources
  be apportioned among firms and industries to
  yield mix of products and services most wanted by
  society
• P MC
• Maximum Consumer and Producer Surplus
• Dynamic Adjustments and Invisible Hand
  Revisited

30
Changes in Supply
S ? MCs
s MC
Economic Profit
ATC
d
111
111
AVC
D
8
8000
Competitive Firm Must Take the Price that
is Established By Industry Supply and Demand
31
Supply Readjustment
S1
MC
ATC
60 50 40
60 50 40
S2
MR
D2
D1
An Increase in Demand Temporarily Raises
Price Higher Prices Draw in New
Competitors Increased Supply Returns Price to
Equilibrium
32
Supply Readjustment
S3
MC
ATC
60 50 40
60 50 40
S1
MR
D1
D3
A Decrease in Demand Temporarily Lowers
Price Lower Prices Drive Away Some
Competitors Decreased Supply Returns Price to
Equilibrium
33
Long-Run Equilibrium

• Competitive Firm and Market

MC
S
PMCMinimum ATC (Normal Profit)
ATC
MR
P
P
D
Qe
Qf
Productive Efficiency Price Minimum
ATC Allocative Efficiency Price MC Pure
Competition Has Both in Its Long-Run Equilibrium
34
Allocative Efficiency and Perfect Competition
35
Perfect Competition

• In a competitive equilibrium, firms make no
  economic profits. Production is efficient in that
  firms produce at their minimum long run average
  cost.
• Firms in competitive industries must move rapidly
  to take advantage of transitory opportunities.
  They also must strive for efficient production in
  order to survive.

36
Perfect Competition

• Some firms in the industry can employ resources
  that give them a competitive advantage (for
  example, an extremely talented manager).
• Yet in such cases, any excess returns often go to
  the factor of production responsible for the
  particular advantage, rather than to the firm's
  owners.

37
The firms short-run supply curve
38
The firms long-run supply curve
39
Competitive equilibrium
40
Barriers to entry

• Although the competitive model provides a useful
  description of the interaction between buyers and
  sellers for many industries,
• there are others where firms have substantial
  market powerprices are affected materially by
  the output decisions of individual firms.

41
Barriers to entry

• extreme case of a firm with market power is
  monopoly, where the industry consists of only one
  firm.
• Here, industry and firm demand curves are one and
  the same.
• A necessary condition for market power to exist
  is that there are effective barriers to entry
  into the industry

42
Barriers to entry

• In contrast to competitive markets, consumers pay
  more than marginal cost and the firm earns
  economic profits.
• Output is restricted from competitive levels.
• With a monopoly, not all the potential gains from
  trade are exhausted

43
Barriers to entry

• Firms consider entering a new market when they
  observe economic profits (higher than normal)
  being reported by firms.
• Entry decisions depends on three important
  factors
• First Whether entry will affect the prices are
  the firms likely to cut prices?

44
Barriers to entry

• Second Incumbent advantages do existing firms
  have advantage that are hard to duplicate, ones
  that make it highly unlikely that the new firms
  will enjoy similar profits.
• Third Cost of Exit how expensive would it be to
  exit if the firm fails
• Market power can exist when there are substantial
  barriers to entry into the industry. Expectations
  about incumbent reactions, incumbent advantages,
  and exit costs all can serve as entry barriers.

45
Barriers to entry - pages 167-169

• Incumbent reactions
• Specific assets
• Economies of scale
• Excess capacity
• Reputation effects

• Incumbent advantages
• Precommitment contracts
• Licenses and patents
• Learning-curve effects
• Pioneering brand advantages

46
Monopoly

• What conditions enable it to arise and survive?
• How does a pure monopolist determine its
  profit-maximizing price and output quantity?
• Does a pure monopolist achieve the efficiency
  associated with pure competition?
• If not, what should the government do about it?

47
Characteristics

• Single Seller
• No Close Substitutes
• Price Maker
• Blocked Entry
• Non-price Competition
• Examples - natural gas electric companies,
  water, cable, local telephone
• Regulated Monopolies
• Unregulated monopolies
• Dual Objectives of Study - not only to understand
  monopolies but more common imperfect competition
  such as monopolistic competition and oligopolies

48
Barriers to Entry

• Economies of Scale public utilities
• Legal Barriers to Entry
• Patents - Pharmaceuticals
• Licenses Radio TV stations, Cabs
• Ownership or Control of Essential Resources
  DeBeers, Alcoa
• Pricing and Other Strategic Barriers to Entry
  Advertising and pricing, Windows

49
Monopolist faces market demand
50
MR - Competitive Firm Versus Monopolist
51
Price and Marginal Revenue
Marginal Revenue is Less Than Price

• A Monopolist is
• Selling 3 Units at
• 142
• To Sell More (4),
• Price Must Be
• Lowered to 132
• All Customers
• Must Pay the Same
• Price
• TR Increases 132
• Minus 30 (3x10)

Loss 30
D
Gain 132
52
Price and Marginal Revenue
Marginal Revenue is Less Than Price

• A Monopolist is
• Selling 3 Units at
• 142
• To Sell More (4),
• Price Must Be
• Lowered to 132
• All Customers
• Must Pay the Same
• Price
• TR Increases 132
• Minus 30 (3x10)
• 102 Becomes a
• Point on the MR
• Curve
• Try Other Prices to
• Determine Other
• MR Points

Loss 30
D
Gain 132
MR
The Constructed Marginal Revenue Curve Must
Always Be Less Than the Price
53
Monopoly Revenue and Costs

• Demand, Marginal Revenue, and Total Revenue for a
  Pure Monopolist

Demand and Marginal Revenue Curves
Elastic
Inelastic
D
MR
Total-Revenue Curve
TR
54
Profit Maximization
By A Pure Monopolist
MC
Pm122
Economic Profit
ATC
D
A94
MRMC
MR
0
55
Misconceptions
Concerning Monopoly Pricing

• Cannot Charge the Highest Price it can get
• Total, Not Unit, Profit is the goal of the
  monopolist
• Possibility of Losses
• However, pure monopolist can continue to receive
  economic profits in the long run

56
Loss Minimization
By A Pure Monopolist
MC
ATC
A
Loss
Pm
AVC
V
D
MRMC
MR
0
Qm
57
Economic Effects of Monopoly

• Price, Output, and Efficiency

Purely Competitive Market
Pure Monopoly
SMC
MC
b
Pm
PMC Minimum ATC
c
Pc
Pc
a
D
D
MR
Qc
Qc
Qm
Pure Competition is Efficient Monopoly Price is
Greater Than MC And Is Therefore Inefficient
58
Perfect Competition Versus Monopoly
59
Monopoly Revenue and Costs

• Monopolist is a Price Maker
• Sets Price in the Elastic Region
• Output and Price Determination
• Cost Data
• MR MC Rule
• No Supply Curve because there is no unique
  relationship between price and quantity supplied.
  The price and quantity supplied will always
  depend on location of the demand curve.

60
Economic Effects of Monopoly

• Price - Monopolist will charge a higher price
  than perfect competition
• Output Monopoly will produce a smaller output
• Productive Inefficiency - output is less than
  the output where ATC is minimum
• Allocative Inefficiency efficiency is not
  achieved because of lower output is produced than
  society is willing and ready to pay for

61
Economic Effects continued

• Deadweight loss - because price exceeds MC there
  is deadweight loss (reduced consumer and producer
  surplus)
• Income Transfer from consumer to producer
• Cost Complications
• Simultaneous Consumption
• Network Effects
• Economies of Scale in one or two companies

62
Monopolistic competition

• Multiple firms produce similar products
• Firms face down sloping demand curves
• Profit maximization occurs where MCMR
• In the long run, firms compete away economic
  profits

63
Monopolistic competition

• Most firms have distinguishable rather than
  standardized products and have some discretion
  over the price they charge.
• Competition often occurs on the basis of price,
  quality, location, service and advertising.
• Entry to most real-world industries ranges from
  easy to very difficult but is rarely completely
  blocked

64
Monopolistic competition

• Monopolistic Competition mixes a small amount of
  monopoly power, a small amount of competition.

65
Monopolistic Competition

• Characteristics
• Small Market Shares
• No Collusion
• Independent Action
• Differentiated Products
• Product Attributes
• Service
• Location
• Brand Names and Packaging
• Advertising
• Some Control Over Price

66
Monopolistic Competition

• Easy Entry and Exit
• Advertising
• Non-price Competition
• Monopolistically Competitive Industries include
  grocery stores, gas station, dry cleaners,
  restaurants
• Firms demand curve is highly, but not perfectly
  elastic because
• It has fewer rivals and products are
  differentiated

67
Price and Output Determination
In Monopolistic Competition

• The Firms Demand Curve Downward sloping
• The Short Run
• Profit or Loss
• The Long Run
• Only a Normal Profit (P ATC but not equal to
  minimum ATC)
• Economic Profits Firms Enter
• Economic Losses Firms Leave
• Complications
• Product Variety

68
Monopolistic competitor in the long run
69
Price and Output Determination
In Monopolistic Competition
Short-Run Profits
ATC
MC
P1
A1
Price and Costs
Economic Profit
D1
MR MC
MR
0
Q1
Quantity
70
Price and Output Determination
In Monopolistic Competition
Short-Run Losses
ATC
MC
A2
P2
Loss
Price and Costs
D2
MR MC
MR
0
Q2
Quantity
71
Price and Output Determination
In Monopolistic Competition
Long-Run Equilibrium
MC
ATC
P3 A3
Price and Costs
D3
MR MC
MR
0
Q3
Quantity
72
Monopolistic Competition and Efficiency

• Recall PMCMinimum ATC

P4
Price is Higher
Excess Capacity at Minimum ATC
Q4
Monopolistic Competition is Not Efficient
73
Inefficiency under monopolistic competition

• Productive Efficiency is not achieved because
  production occurs where ATC is greater than
  minimum ATC.
• Allocative Efficiency is not realized because the
  product price exceeds marginal cost

74
Oligopoly

• A few firms produce most market output
• Products may or may not be differentiated
• Effective entry barriers protect firm
• Profitability However, these profits can be
  eliminated through competition among existing
  firms in the industry.
• Firm interdependence requires strategic thinking

75
Oligopoly

• To analyze output and pricing decisions in
  oligopolistic industries, we use the concept of a
  Nash equilibrium
• A Nash equilibrium exists when each firm is doing
  the best it can given the actions of its rivals.

76
Oligopoly

• Characteristics
• A Few Large Producers
• Homogeneous or Differentiated Products
• Homogeneous, Steel, copper, cement
• Differentiated, Auto, detergents
• Control Over Price, But Mutual Interdependence
• Strategic Behavior
• Entry Barriers, economies of scale, large capital
  investments, patents, control of raw material,
  advertising, brand loyalty and pricing
• Oligopoly Through Mergers

77
The Nash equilibrium

• An oligopolist does the best it can, given
  expectations of rival behavior
• Behaviors are noncooperative
• Duopolists considering a low price or a high
  price must consider rivals response
• Nash equilibrium occurs when each firm does the
  best it can given rivals actions

78
The Nash equilibrium

• The Nash equilibrium is not the outcome that
  maximizes the joint profits of the two companies
• Combined profits could be higher if the two
  companies decide to cooperate

79
Determining the Nash equilibrium
80
Game Theory

• Game Theory Model to Analyze Behavior

RareAirs Price Strategy

• 2 Competitors
• 2 Price Strategies
• Each Strategy Has a Payoff Matrix
• Greatest Combined
• Profit
• Independent Actions
• Stimulate a Response

High
Low
A
B
12
15
High
12
6
Uptowns Price Strategy
C
D
6
8
Low
15
8
81
Game Theory

• Game Theory Model to Analyze Behavior

RareAirs Price Strategy

• Independently Lowered Prices in Expectation of
  Greater Profit Leads to the Worst Combined
  Outcome
• Eventually Low Outcomes Make Firms Return to
  Higher Prices

High
Low
A
B
12
15
High
12
6
Uptowns Price Strategy
C
D
6
8
Low
15
8
O 11.2
82
Cournot model of Duopoly

• In the Cournot model, each firm treats the output
  level of its competitor as fixed and then decides
  how much to produce.
• In equilibrium, firms make economic profits.
• However, these profits are not as large as would
  be made if the firms effectively colluded and
  posted the monopoly price.

83
Cournot equilibrium
84
Oligopolies - other models

• Other models of oligopoly yield different
  equilibriums. For instance, one model based on
  price competition yields the competitive
  solution Price equals marginal cost with no
  economic profits.
• Economic theory makes no clear-cut prediction
  about the behavior of firms in oligopolistic
  industries.
• Available evidence suggests that in some
  oligopolistic industries, firms restrict output
  from competitive levels and hence capture some
  economic profits.

85
Oligopolies and Joint Profit Maximization

• It is in the economic interests of firms in
  oligopolistic industries to find ways to
  cooperate, thereby capturing higher profits.
• Even when firms are free to cooperate, effective
  cooperation is not always easy to achieve.
  Individual firms have incentives to deviate from
  agreed-on outputs and prices and increase their
  revenues and profits

86
Prisoners' dilemma

• This incentive is illustrated by the prisoners'
  dilemma.
• This model highlights incentives that can cause
  cartels to be unstable. However, firms sometimes
  can cooperate successfully when they can impose
  penalties on non-cooperative firms. Cooperation
  also can be sustained through the incentives
  provided by long-run, repeated relationships.

87
The classic prisoners dilemma
88
The cartels dilemma
89
The End

• Online Quiz
• Current Events
• Concept Questions
• Test