Transcript Chapter 11 - Imperfect Competition

Chapter 11
Imperfect
Competition
© 2004 Thomson Learning/South-Western
Imperfect Competition
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Pricing in these markets falls between perfect
competition and monopoly.
Three topics considered:
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Pricing of homogeneous goods in markets with few
firms.
Product differentiation in these markets.
How entry and exit affect long-run outcomes in
imperfectly competitive markets.
Pricing of Homogeneous Goods
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In this market a relatively few firms produce a
single homogeneous good.
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Assume demanders are price takers.
Assume there are no transactions or informational
costs.
These assumptions result in a single
equilibrium price for the good.
Initially, assume a fixed, small number of
identical firms.
Quasi-Competitive Model
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A model of oligopoly pricing in which each firm
acts as a price taker even though there may be
few firms is a quasi-competitive model.
As a price taker, a firm will produce where price
equals long-run marginal costs.
This equilibrium will resemble the perfectly
competitive solution, even with few firms.
Quasi-Competitive Model
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In Figure 11.1, the quasi-competitive
equilibrium is PC (= MC), QC.
This equilibrium represents the highest quantity
and lowest price that can prevail in the long run
given the demand curve D.
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A lower price would not be sustainable in the long
run because it would not cover average costs.
FIGURE 11.1: Pricing under
Imperfect Competition
Price
P
C
C
MC
D
MR
6
0
Q
C
Quantity
per week
Cartel Model
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A model of pricing in which firms coordinate
their decisions to act as a multiplant monopoly
is the cartel model.
Assuming marginal costs are constant and
equal across firms, the cartel output is point M
(the monopoly output) in Figure 11.1.
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The plan would require a certain output by each firm
and how to share the monopoly profits.
FIGURE 11.1: Pricing under
Imperfect Competition
Price
P
P
P
M
M
A
A
C
C
MC
D
MR
8
0
Q
M
Q
A
Q
C
Quantity
per week
Cartel Model
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Maintaining this cartel solution poses three
problems:
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Cartel formations may be illegal, as it is in the U.S.
by Section I of the Sherman Act of 1890.
It requires a considerable amount of costly
information be available to the cartel.
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The market demand function.
Each firm’s marginal cost function.
Cartel Model
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The cartel solution may be fundamentally unstable.
 Each member produces an output level for which
price exceeds marginal cost.
 Each member could increase its own profits by
producing more output than allocated by the
cartel.
 If the cartel directors are not able to enforce their
policies, the cartel my collapse.
APPLICATION 11.1: The De Beers Cartel
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In the 1870s the discovery of the rich diamond
fields in South Africa lead to major gem and
industrial markets.
After a competitive start, the ownership of the
richest mines became incorporated into the De
Beers Consolidated Mines which continues to
dominate the world diamond trade.
APPLICATION 11.1: The De Beers Cartel
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Operation of the De Beers Cartel
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Since the 1880s diamonds found outside of South
Africa are usually sold to De Beers who markets the
diamonds to the final consumers through its central
selling organization (CSO) in London.
By controlling supply, the CSO maintains high prices
which have been estimated to be as much as one
thousand times marginal cost.
APPLICATION 11.1: The De Beers Cartel
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Dealing with Threats to the Cartel
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This large markup promotes threat of entry with any
new diamond discovery.
De Beers has used its market power to control
would-be-chiselers.
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They drove down prices when the former Soviet Union and
Zaire tried market entry in the 1980s.
New finds in Australia were sold to the CSO rather than try
to fight the cartel.
APPLICATION 11.1: The De Beers Cartel
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The Glamour of D Beers
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De Beers controls most print and television
advertising, including “Diamonds Are Forever”.
They convinced Japanese couples to adopt the
western habit of buying engagement rings.
De Beers has attempted to generate a brand name
with customers to get consumers to judge De Beers
diamonds superior to other suppliers.
The Cournot Model
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The Cournot model of duopoly is one in which
each firm assumes the other firm;s output will
not change if it changes its own output level.
Assume
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A single owner of a costless spring.
A downward sloping demand curve for water has
the equation Q = 120 - P.
The Cournot Model
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As shown in Figure 11.2, the monpolist would
maximize profit by producing Q = 60 with a
price = $60 and profits (revenue) = $3600.
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Note, this output equals one-half of the quantity that
would be demanded at a price of zero.
Assume a second spring is discovered.
FIGURE 11.2: Spring Monopolist’s
Output Choice
Price
120
60
MR
17
0
D
60
120
Output
per week
Duopoly Model
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Cournot assumed that firm A, say, chooses its output
level (qA) assuming the output of firm B (qB) is fixed
and will not adjust to A’s actions.
The total market output is given by
Q  q A  qB  120  P
Assumingq B is fixed, A' s demand curveis
q A  (120  qB )  P.
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Duopoly Model
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If the demand curve is linear, the marginal
revenue curve will bisect the horizontal axis
between the price axis and the demand curve.
Thus, the profit maximizing point is given by
120  q B
qA 
.
2
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[11.4]
Duopoly Model
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If firm B chooses to produce 60 units, firm A
would choose 30 [=(120 - 60)  2].
Equation 11.4 is called a reaction function
which, in the Cournot model, is a function or
graph that shows how much one firm will
produce given what the other firm produces.
FIGURE 11.3: Cournot Reaction
Functions in a Duopoly Market
120
Output of
firm B(qB)
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Firm A’s reactions
0
60
120
Output of
firm A(qA)
Duopoly Model
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Firm A’s reaction function is shown in Figure 11.3.
Firm B’s reaction function is given below and also
shown in Figure 11.3
120  q A
qB 
2
22
[11.5]
FIGURE 11.3: Cournot Reaction
Functions in a Duopoly Market
120
Output of
firm B(qB)
Firm A’s reactions
60
Equilibrium
Firm B’s reactions
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0
60
120
Output of
firm A(qA)
Cournot Equilibrium
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The actions of the two firms are consistent with
each other only at the point where the two lines
intersect.
The point of intersection is the Cournot
equilibrium, a solution to the Cournot model in
which each firm makes the correct assumption
about what the other firm will produce.
FIGURE 11.3: Cournot Reaction
Functions in a Duopoly Market
120
Output of
firm B(qB)
Firm A’s reactions
60
Equilibrium
40
25
Firm B’s reactions
0
40
60
120
Output of
firm A(qA)
Cournot Equilibrium
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In this Cournot equilibrium each firm produces 40 units
of output.
q A  40
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qB  40.
Total industry profit is $3,200, $1600 for each firm).
Because the firms do not fully coordinate their actions,
their profits are less than the cartel profit ($3,600) but
much greater than the competitive solution where P =
MC = 0.
Price Leadership Model
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A model in which one dominant firm takes
reactions of all other firms into account in its
output and pricing decisions is the price
leadership model.
A formal model assumes the industry is
composed of a single price-setting leader and
a competitive fringe which is a group of firms
that act as price takers.
Price Leadership Model
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This model is shown in Figure 11.4.
The demand curve D represents the total
demand curve for the industry’s product.
The supply curve SC represents the supply
decisions of all the firms in the competitive
fringe.
FIGURE 11.4: Formal Model of Price
Leadership Model
Price
SC
D
29
0
Quantity
per week
Price Leadership Model
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The demand curve (D’) for the dominant firm
is derived as follows:
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For a price of P1 or above the competitive fringe
will supply the entire market.
For a price of P2 or below, the dominant firm will
supply the entire market.
Between P2 and P1 the curve D’ is constructed by
subtracting what the fringe will supply from the total
market demand.
FIGURE 11.4: Formal Model of Price
Leadership Model
Price
SC
P1
D’
P
2
D
31
0
Quantity
per week
Price Leadership Model
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Given D’, the leader’s marginal revenue curve
is MR’ which equals the leader’s marginal cost
(MC) at the profit maximizing level QL.
Market price is PL and equilibrium output is QT
(= QC + QL).
The model does not explain how the leader is
chosen.
FIGURE 11.4: Formal Model of Price
Leadership Model
Price
SC
P1
D’
P
P
L
2
MC
MR’
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0
Q
C
Q Q
L
T
D
Quantity
per week
APPLICATION 11.2: Cournot in
California
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Borenstein and Bushnell paper: Perhaps the
most elaborate attempt at modeling the impact
of electricity deregulation in California.
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Authors focus on competition between the three
major electricity-generating firms.
They argue that the smaller suppliers can be treated
as competitive suppliers but that the major in-state
producers behave in the way assumed in the
Cournot model.
APPLICATION 11.2: Cournot in
California
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Borenstein and Bushnell show that under certain
circumstances there is substantial market power in
California wholesale electricity markets.
One way to measure that power is by the Lerner Index,
the ratio (P – MC/P).
The authors showed with the Lerner Index that during
peak periods, equilibrium in these markets is far from
the competitive ideal.
They also show that market power can be significantly
restrained by larger price elasticities of demand for
electricity.
Product Differentiation: Market
Definition and Firms Choices
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A product group is a set of differentiated
products that are highly substitutable for one
another.
Assume few firms in each product group.
Firms will incur additional costs to differentiate
their product up to the point where the
additional revenue from this activity equals the
marginal cost.
Product Differentiation: Market
Equilibrium
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The demand curve for each firm depends on
the prices and product differentiation activities
of its competitors.
The firm’s demand curve may shift frequently,
and its position at any point in time may only
be partially understood.
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Each firm must make assumptions about its
competitors’ actions, and whatever one firm
decides may affect its competitor’s actions.
APPLICATION 11.3: Price Leadership in
Financial Markets
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The Prime Rate at New York Commercial
Banks
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Major New York commercial banks quote a “prime
rate” which purports to be the interest rate that they
charge on loans to their most creditworthy
customers.
Recent research indicates actual pricing is more
complex, but the prime provides a visible and
influential indicator or rate change.
APPLICATION 11.3: Price Leadership in
Financial Markets
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While rates changes are sluggish, when “large”
changes (0.25 or more) are required one of the
major banks will act like a leader and
announce a new prime rate on a trial basis.
After a few days, either most banks will follow
or the initiator will return to its old rate.
APPLICATION 11.3: Price Leadership in
Financial Markets
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A number of researchers have found that rates tend
to rise soon after an increase in bank costs, but
decline only slowly when costs fall.
Similarly, a rise in the prime tends to hurt the stock
prices of banks that increase because the increase
signals that profits hare being squeezed by costs.
Alternatively, stock prices rise when the prime rate
falls.
APPLICATION 11.3: Price Leadership in
Financial Markets
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Price Leadership in the Foreign Exchange
Market
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The large market for world currencies is dominated
by major financial institutions and is heavily
influenced by the “intervention” of various nations’
central banks.
Because central bank intervention is not announced
in advance, well informed traders may have an
information market advantage.
APPLICATION 11.3: Price Leadership in
Financial Markets
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In a study of the German Mark (DM), an author
found that one bank tended to pay the role of leader
in setting the DM/$ exchange rate.
This leadership role arose because of the bank’s
ability to foresee intervention by the German central
bank in exchange markets.
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Quoted exchange rate between 25 and 60 minutes before
the intervention were copied by other banks, while within
25 minutes (with information more diffused) no clear cut
pattern emerged.
APPLICATION 11.4: Competition in
Breakfast Space
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Industrial Concentration
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Three major firms control approximately 80 percent
of the market.
Returns on invested capital are more than double
those of the average industry.
It is unclear why the market is not more competitive
since there do not seem to be any major economies
of scale and no obvious barriers to entry.
APPLICATION 11.4: Competition in
Breakfast Space
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The FTC Complaint and Product Differentiation
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In 1972 the U.S. Federal Trade Commission (FTC)
claimed the largest producers actions tended to
establish monopoly-like conditions.
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Proliferation of new, highly advertised, brands left no room
for potential new entrants.
Brand identification also prevented new entrants from
duplicating existing cereal.
APPLICATION 11.4: Competition in
Breakfast Space
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Demise of the Legal Case
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Firms claimed that they were engaging in active
competition by creating new cereal brands.
Also, many new “natural” cereals did enter the
market in the 1970s.
The case was quietly dropped in 1982.
Recent studies still indicate a lack of
competition and continued higher profits.
APPLICATION 11.4: Competition in
Breakfast Space
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One of illustrating the contention that major
firms so proliferated their brands so as to keep
potential competitors out was developed by S.
Salop.
Figure 1 depicts consumers evenly located
along the circle which may represent an actual
geographic space or product space.
The presence of two firms (A and B) with two
products each deters entry by C.
Application Figure 1: Salop’s Model of
Spatial Competition.
A1
.
.
B1
C
.
B2
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.
A2
Product Differentiation: Entry by
New Firms
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The degree to which firms can enter the market
plays an important role.
Even with few firms, to the extent that entry is
possible, long-run profits are constrained.
If entry is completely costless, long-run
economic profits will be zero (as in the
competitive case).
Monopolistic Competition
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If firms are price takers, P = MR = MC for profit
maximization.
Since P = AC, if entry is to result in zero profits,
production will take place where MC = AC (at
minimum average cost).
If, say through product differentiation, firms
have some control over price, each firm faces
a downward sloping demand curve.
Monopolistic Competition
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Entry still may reduce profits to zero, but
production at minimum cost is not assured.
Monopolistic competition is a market in
which each firm faces a negatively sloped
demand curve and there are no barriers to
entry.
This type of market is illustrated in Figure 11.5.
FIGURE 11.5: Entry Reduces
Profitability in Oligopoly
Price,
costs
d
mr
MC
AC
P*
0
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q*
Quantity
per week
Monopolistic Competition
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Initially the demand curve is d, marginal
revenue is mr, and q* is the profit-maximizing
output level.
If entry is costless, the entry shifts the firm’s
demand curve inward to d’ where profits are
zero.
At output level q’, average costs are not
minimum, and qm - q’ is excess capacity.
FIGURE 11.5: Entry Reduces
Profitability in Oligopoly
Price,
costs
d
mr
MC
AC
d’
P*
P’
mr’
0
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q’
q* qm
Quantity
per week
Sustainability of Monopolistic
Competition
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Monopolistic competition focuses only on the
behavior of actual entrants but ignores the
effects of potential entrants.
A broader perspective of the “ invisible hand” is
the distinction between competition in the
market and competition for the market.
Determination of Industry Structure
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Let q* represent that output level for which
average costs are minimized.
Let Q* represent the total market for the
commodity when price equals market (and
average) cost.
The number of firms, n, in the industry (which
may be relatively small) is given by
Q*
n *
q
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[11.7]
Determination of Industry Structure
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As shown in Figure 11.6, for example, only four
firms fulfill the market demand Q*.
The contestability assumption will ensure
competitive behavior even though firms may
recognize strategic relationships among
themselves.
The potential for entrants constrains the types
of behavior that are possible.
FIGURE 11.6: Contestability and
Industry Structure
Price
AC 2
AC 1
AC 3
AC 4
P*
D
0
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q*
2*
q
3*
q
Q* = 4*
q
Quantity
per week
APPLICATION 11.4: Airline
Deregulation Revisited
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Airlines Contestability
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Since planes are mobile, they can be moved into a
market that promises excess profits.
Such potential entry should hold prices at
competitive levels even with few firms.
However, terminal facilities are market specific and
brand loyalty appears to exist.
Also, some major airports have limited potential for
growth.
APPLICATION 11.4: Airline
Deregulation Revisited
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Effects of Deregulation
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Studies suggest that fares declined after
deregulation with one study suggesting yearly gains
to customers of about $8.6 billion.
However, this study found that additional welfare
gains of about $2.5 billion were not realized
because of the limitations of landing slots and
computer reservations systems may aid in price
collusion among major airlines.
APPLICATION 11.4: Airline
Deregulation Revisited
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Trend in Airline Competition
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Many new airlines entered after the 1978
deregulation, but they were often consolidated into
larger carriers.
Several existing airlines went out of business.
The hub-and-spoke designs of flight networks were
introduced which has lead to dominance of one or
two airlines in a hub city which may have resulted in
higher fares.
Barriers to Entry
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The existence of barriers to entry change the
type of analysis.
In addition to those previously discussed,
barriers include brand loyalty and strategic
pricing.
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Firms may drive out potential entrants with low
prices followed later by price increases or they may
buy up smaller firms.