Imperfect Competition

1
Imperfect Competition

• Characteristics Behavior of Firms With Market
  Power

2
Objectives of Discussion

• Consider what it means for a firm to have market
  power
• Examine some measures of market power
• Consider some of the factors that will create
  market power for a firm
• Examine the optimizing behavior of a monopoly
  firm
• Examine the monopoly firms short-run long-run
  equilibrium
• Examine the monopoly firms optimal resource
  utilization behavior
• Examine Output decisions for multi-plant firms

3
Market Power

• A firm has Market Power (MP) if it can raise
  its price without losing all of its sales
• Consider case of firm in perfect
  competition--what happens when it tries to raise
  price
• Implications of market power
• Firms demand curve is downward sloping
• No perfect substitutes for its products
• Gives firm ability to raise price above average
  cost earn economic profit (if demand cost
  conditions permit)
• Almost all firms have some degree of market power
• Degree of market power varies greatly from
  industry to industry
• Local gas/convenience stores have market power
  based on location
• Major department stores have market power based
  on location and advertising induced name
  recognition

4
Measures of Market Power

• Most direct measure of firms MP is the price
  elasticity of demand for its product
• The more inelastic the firms demand, the greater
  its MP
• Note the emphasize on the firm as opposed to the
  industry elasticity
• A secondary set of measures of MP is the
  cross-elasticity of firms product with respect
  to possible substitutes
• Relatively high positive cross-elasticity
  coefficients indicates that there are close
  substitutes and firms MP is limited
• Cross-elasticity is frequently used in anti-trust
  cases to determine if products are viewed as
  competitors
• Lerner Indexbased on how much a firm can raise
  its price above its MC

5
Lerner Index

• Lerner index measures proportionate amount by
  which price exceeds marginal cost
• Equals zero under perfect competition because Q
  is chosen where P MC
• Increases as market power increases
• Also equals 1/E, which shows that the index (
  market power), vary inversely with elasticity
• The lower the elasticity of demand (absolute
  value), the greater the index the degree of
  market power

6
Determinants of Market Power

• Ease of entry
• Entry of new firms erodes market power of
  existing firms
• Excessive economic profits by existing firms
  provides incentive for new firms to enter
• More firms means more substitutes
• Strong barriers to entry must exist to sustain a
  high degree of market power

7
Barriers to Entry Market Power

• Barriers to Entry (BtoE) are technical,
  governmental or economic factors that impede
  entry of firms into a market
• Limits potential substitutes
• Large Minimum Efficient Economies of Scale
• Capacity of firm required to achieve lowest point
  on LAC curve is large relative to total market
  demand
• Large capital investment required to achieve
  competitive cost level
• Significant cost disadvantages for smaller firms
• Number of firms required to satisfy total market
  demand is small

8
Other Barriers to Entry

• Government created BtoEs
• Licensing franchises--e.g. local telephone
  companies, trash collection, toll roads, etc
• Federally granted patents on products processes
  
• Control of, or limited access to, resource
  markets
• Classic case was ALCOAs control of bauxite
  before WWII
• Walmart is frequently accused of controlling
  suppliers interactions with competitors
• Advertising Brand Loyalties
• Soft drinks chewing gum are classic examples
• Beauty products and cosmetics are other examples
• Cost of entry for a new firm is an overwhelming
  advertising budget

9
Other Entry Barriers

• Consumer lock-in
• Potential entrants can be deterred if they
  believe high switching costs will keep them from
  inducing many consumers to change brands
• Cell phone contracts, internet contracts, etc.
• Network externalities
• Occur when value of a product increases as more
  consumers buy use it
• Make it difficult for new firms to enter markets
  where firms have established a large network of
  buyers
• Cell phones, internet access, computer software,
  etc.

10
Profit Maximization in Monopoly

• Single firm
• Produces sells a good or service for which
  there are no good substitutes
• New firms are prevented from entering market
  because of a barrier to entry

11
Monopoly Firms Demand MR

• Firms demand curve is the downward sloping
  market demand curve
• Firm must accept a reduction in price if it
  desires to sell more

Point of unitary E

• Firms MR curve deviates from its demand AR
  curve
• For linear demand, MR declines twice as fast as
  demand
• MR becomes zero at quantity at which demand
  elasticity is unitary
• MR is only positive when
• E gt 1

12
Profit Maximization for Monopoly Firm

• Short-run cost curves for monopoly firm are same
  u-shaped curves as PC
• Like firm in PC, monopolist chooses Q where its
  MR MC

Profit 1,400

• Firm then sets price that market will bear for
  that quantity

pMax

• Firms profits are (P - ATC) x Q
• Profits represented by rectangle ABCD equal
  1,400

13
Losses in Short-run

• Monopolist not always guaranteed profit
• Like firm in PC, monopolist will operate with
  loss in SR as long as can cover all of AVC
• Firm chooses Q where MR MC sets price along
  demand
• In this case, firm suffers loss represented by
  ABCD
• Loss (P - ATC) x Q
• Loss (75 - 80) x 50 - 250

Loss ABCD (P ATC)Q (75 80) x 50 - 250
14
Long-run Equilibrium for Monopoly Firm

• Monopolist does not have to maximize profits to
  survive
• In LR, monopoly firm will not operate with loss
• Firms LR cost curves are similar to those of PC
  firm

• Once LR plant size is chosen, firm will operate
  along its SR cost curves

• At LR equilibrium, firm will choose Q where
  MRLMCSMC
• Firm may make profits, or break even, but will
  not suffer a loss

15
Optimal Hiring Decision for Monopolist

• Monopolists optimal hiring rule is similar to
  that of PC firm
• Expand use of factor as long as its MRP MC
• Main difference between Monopolist PC is way
  MRP is determined
• For monopolist MRP MR x MP whereas for PC firm
• MRP P x MP
• Monopolist must reduce P to sell the additional
  MPL
• MRP for monopolist declines faster than MRP for PC

16
Profit-Maximizing Input Usage

• For a firm with market power, profit-maximizing
  conditions MRP w and MR MC are equivalent
• Whether Q or L is chosen to maximize profit,
  resulting levels of input usage, output, price,
  profit are the same

17
Monopolistic Competition

• Large number of firms sell a differentiated
  product
• Products are close (not perfect) substitutes
• Market is monopolistic
• Product differentiation creates a degree of
  market power
• Market is competitive
• Large number of firms, easy entry

18
Monopolistic Competition

• Short-run equilibrium is identical to monopoly
• Choose Q where MR MC
• Set price on basis of willingness to pay as
  reflected by the demand curve
• Long-run equilibrium
• Excessive economic profits provide incentive for
  entry
• Unrestricted entry/exit reduces each existing
  firms demand and increases cost
• Long-run equilibrium attained when demand curve
  for each producer is tangent to its LAC
• At equilibrium output, P LAC and MR LMC
• However, does operate at minimum LAC and P gt LMC

19
Short-Run Profit Maximization for Monopolistic
Competition
20
Long-Run Profit Maximization for Monopolistic
Competition
21
Maximizing Profit at Aztec Electronics An
Example

• Aztec possesses market power via patents
• Sells advanced wireless stereo headphones

22
Estimate Aztec Electronics Demand Function

• Assume the following demand function was
  estimated where P is price, M is income and PR is
  the price of a related good
• Substituting for M PR
• The direct demand function is

Q 50,000 500P
23
Inverse Demand for Aztec Electronics

• Start with direct demand function
• Divide all terms by -500
• Solve for P
• Inverse demand function is

P 100 - .002Q
24
Determine MR Function

• Multiple Inverse Demand by Q to find TR
• MR is 1st Derivative of TR

25
Demand Marginal Revenue for Aztec Electronics
26
Estimating AVC MC

• Given the estimated AVC equation
• Find TVC
• Find SMC

27
Find pMax Output for Aztec

• Set MR MC and put equation in general quadratic
  equation form

0 -72 - 0.006Q 0.000003Q2
28
Find pMax Output for Aztec

• Plug coefficients into quadratic formula

29
Finding P

• Pricing decision
• Substitute Q into inverse demand

P 88
30
Aztecs Shut-Down Point

• Shutdown decision
• Compute AVC at 6,000 units

31
Total Profit at Aztec Electronics

• Computation of total profit

32
Profit Maximization at Aztec Electronics
33
A Multiplant Firm
Firm produces in 2 plants A B
Set each plants Q where MR MCT MCA MCB