Imperfect competition

Imperfect Competition

• The spectrum of competition: Perfect Comp. ------------- Monopoly Monop. Comp.-- Oligopoly • Assumptions underlying oligopoly

– Few Sellers• Interdependence – each seller must be aware that their actions will

provoke actions by rival firms

– Differentiated versus non-differentiated products (cars or oil• Differentiated products leads to non-price competition through

activities such as advertising, style changes, quality

Cartels

• Explicit agreements among firms to fix output and prices and act as a monopolist.

• Examples are OPEC, Electrical Conspiracy (Econ USA), Shipping Cartel

• Incentive to cooperate – earn monopoly profits• Incentive to cheat – increase individual profits if cheating is not

detected or punished.• Sources of instability in cartels:

– Number of Sellers– Cost differences– Potential competition– Recessions– Cheating

Cartels and Government

• Monopoly power is often granted by government via regulation. Example Ma Bell (Econ USA).

• Other examples are shipping and the airline industry (pre-deregulation).

• Justifications for government regulation include infant industry and natural monopoly.

• Criticisms include decreased competition, increased costs due to x-inefficiency and lobbying, and regulation outlives its usefulness.

Links

• http://www.sunship.com/mideast/oil.html

• http://www.eia.doe.gov/emeu/cabs/chron.html

• http://www.naseo.org/energy_sectors/fossil/oil/Supply_Graphs.htm#Prices,%201973-97

Measuring Market Power : Market Concentration

• One presumption is that as the number of sellers decreases, market power increases.

• Concentration Ratios – percentage of market share controlled by x number of firms, most commonly a four-firm concentration ratio

• Four-firm concentration ratio = (Sales by four largest firms in an industry/Sales by all firms in the industry) x 100

Concentration RatiosPrimary Copper (1992,2002) 98,95

Cigarettes 93,99

Beer 90,90

Breakfast Cereals 85,83

Motor Vehicles 84,83

Greeting Cards 84

Small-arms munitions 84,89

Household Refrigerators and Freezers

82,82

McConnell and Brue, “Economics” and US Census

Problems with Concentration Ratios

• Do not take into account foreign competition

• Fail to account for potential competition. – Contestable markets – firms are able to enter

and exit at low cost. Potential entry acts as a limit to market power.

US Auto Industry 2001GM 27

Ford 24

Daimler-Chrysler 16

Toyota 10

Honda 7

Nissan 4

Mitsubishi 2

Mazda 2

Subaru 1

Suzuki .3

4 US firms Control 67%

Japanese FirmsControl26%

WSJ 4/4/2001 and Carbaugh page 201

Mergers – Increasing Concentration

• Vertical Merger – merging with a firm that supplies inputs

• Horizontal Merger – merging with a competitor • Conglomerate Merger –merging with firms that

are not related• Successful mergers – Boeing and McDonnell-

Douglas• Unsuccessful Mergers – AOL Time Warner

Game Theory

• Game theory is an attempt to model and understand behavior given the presence of interdependence

• Games have the following characteristics:– Rules– Strategies– Payoffs– Outcome

The Prisoner’s Dilemma

• Two criminals, Bill and Paul, are caught red-handed stealing a car, and will receive 2 year sentences; however, they become suspects in a previous bank robbery. The DA’s job is to see if he can solve the bank robbery.– Rules:

• Each player is held in separate rooms and cannot communicate.

• Each is told that he is suspected of the larger crime and– if both confess to the bank robbery, they get 5 year sentences– if one rats on the other and the other does not confess to the bank

robbery, he gets off, and the other gets a 10 year sentence

– Strategies: Each player has two possible actions• Confess to the bank robbery

• Do not confess to the bank robbery

– Payoffs: Two players with two outcomes four possible outcomes with the following payoffs

• Both confess – each get 5 year sentences

• Both deny – each get 2 year sentence

• Bill confesses and Paul denies – Bill gets off and Paul gets 10 years

• Paul confesses and Bill denies – Paul gets off and Bill gets 10 years.

BILL

PAUL

ConfessDeny

Confess

Deny

5 years 10 years

5 years Off

Off 2 years

10 years 2 years

Bill

Paul

Paul – if Bill confesses I should too (5 vs 10), if Bill denies, I shouldstill confess (off vs 2)Bill – if Paul confesses I should too (5 vs 10); if Paul doesn’t. I should still confess (off vs 2)

Kinked Demand Curve Model

• Show a situation where the best situation for players is to maintain current prices and that prices remain stable in spite of firms with different cost structures.

• Asymmetry in price movements:– If firm raises price, no one follows, therefore quantity demanded is

elastic

– If firm lowers price, all follow suit so the quantity demanded is quite inelastic

• Marginal revenue curve is discontinuous and allows for various marginal cost curves.

Kinked Demand Curve

– If the firm raises its price above P, it faces an elastic demand curve, payoff low

– If the firm lowers its price below P, it faces an inelastic demand curve, payoff low

Kinked Demand Curve– Different firms can have

different MCs. As long as they fall with in the discontinuous MR, P will remain stable.

– Output Effect < Price Effect for price movements with the discontinuous MR curve.

– If MC increases enough, all firms raise their prices and the kink vanishes.

Dominant Firm Price Leadership

• A large dominant firm with lower costs that it competitors becomes the price maker.

• A competitive fringe with many firms that are price takers or followers.

• The dominant firm’s demand curve is the total market demand minus the supply of the competitive fringe.

• The dominant firm sets price and its quantity based upon residual demand and this determines the price for competitive firms and their supply. (Examples OPEC).

Dominant Firm– The large firm can set the price and receives a marginal

revenue that is less than price along the curve MR.

ResidualDemand

Dominant Firm’sDemand Curve

Dominant Firm– As long as the dominant firm has lower costs, it can act like

a monopolist over the residual demand.

Other Price Leadership Models

• Barometric price leadership - firms come to tacit agreement to allow one firm to set the price according to cost consideration. If cost move is justified, others will follow and validate the price . If not, or if some firm decides to defect, the price change will not be validated.

• Rotating price leadership – firms come to tacit agreement to allow the price leading firm to rotate among key players in the industry.

Oligopoly and Efficiency

• The question whether oligopoly affects economic welfare depends on whether or not they exercise market power over prices and production

• In competition, the level of output produced is where P=MC or MB=MC. Hence, net benefits to society are maximized. Market prices as low as possible and respond to changes in market forces. This allows prices to help direct resource allocation.

• In monopoly, the level of output produced is where P>MC or MB>MC. Hence, net benefits to society are NOT maximized. Market prices are higher and respond to changes in market forces. This allows prices to help direct resource allocation.

• In oligopoly, the level of output is somewhere between the competitive and the monopolistic outcome. As the oligopolist produces closer to the competitive solution, the net benefits to society move closer to being maximized. The opposite is true if the outcome moves closer to the monopoly outcomes, such as occurs with a perfect carte.

• Non-price competition, such as advertising and product differentiation, can negatively affect resource allocation, but it can also contribute to efficiency. People have different preferences for products and advertising can help inform consumers about the price and nature of a product.

• If prices are sticky, they can also cause inefficiency by failing to act as signals for resource allocation.

• The extent of these inefficiencies are the subject of debate among economists and non-economists.

Market Structures: Monopolistic Competition

Imperfect Competition• The spectrum of competition: Perfect Comp. ------------- Monopoly Monop. Comp.-- Oligopoly • Assumptions underlying Monopolistic Competition

– Differentiated products • Differentiated products leads to some market power over price or a

downward slping demand curve

– Many buyers and sellers– Free entry and exit– Perfect knowledge

Short-run Vs. Long-run Supply Decisions

• In the short-run, the firm is able to set prices like a monopolistic. P>MR so MR=MC implies that P>MC. A firm can make profits, breakeven or make losses.

• In the long-run, free entry and exit will eliminate economic profits or losses.

• In either case, the monopolistically competitive firm produces a level of output where LRAC are greater than LRAC minimum or the efficient scale and sets price above MC.

Monopoly Competition and Economic Welfare

• Compared to competitive markets, monopolistic competition results in an output level where there is – Excess capacity – LRAC >LRAC min– P>MC - or MB>MC– So, Deadweight Welfare Loss exists

• Welfare loss is due to product differentiation– If differentiation is real, the welfare is small– If differentiation is the result of advertising which does

not contribute anything to consumer satisfaction, it represents welfare loss

Advertising

• Advertising is costly, the question is - does it add anything of value to the consumer?– informative advertising which contributes to

competition

– Advertising aimed at creating perceived differences or brand loyalty

– Breakfast cereals and kids versus supermarket ads

• Advertising and the prisoner’s dilemma – self-canceling ads.