Chapter 9. Noncompetitive Markets and Inefficiency. Copyright 2011 Pearson Addison-Wesley. All rights reserved.

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1 Chapter 9 Noncompetitive Markets and Inefficiency

2 FIGURE 9.BP.1 Market Structures and Their Characteristics 9-2

3 Monopoly Monopoly Characteristics: 1 firm, no close substitutes, so the firm can set Price. Downward-sloping Demand Curve The monopoly s D curve is the mkt. D curve Barriers to Entry: factors keep out competitors 9-3

4 Barriers to Entry Economies of Scale (Natural Monopoly): More efficient to be big Declining LRAC curve, better to have only 1 firm Exclusive Ownership of a Unique Resource Alcoa & Bauxite, Diamonds & DeBeers Govt. Granted Monopoly Franchises granted to cable co., electric co., post office Patents & Copyrights Monopoly on a drug formula (AZT), operating system (Windows), etc. The existence of Barriers to entry means that a monopolist CAN earn economic profit in long run 9-4

5 Profit Max. for a Monopolist: produce as long as MR MC, but MR P Perfect Competition, MR=P Monopoly, P>MR P Q TR MR P Q TR MR

6 Price & Marginal Revenue When P is fixed, P=MR When P as Q, P=MR at Q=1, and then P>MR As the firm lowers prices to sell more units, each unit makes you more $, but you lose some money by lowering P 2nd unit sells when P=$9; MR is only $8 b/c the firm had to lower P by $1 to sell another unit => make $9 more, lose $1 from lower prices 3rd unit sells if P=$8; but MR is $6. Profit Max now occurs where MR=MC, not where P=MC. 9-6

7 D & MR under Perfect Competition vs. Monopoly P Perfect Competition P Monopoly D=MR D Q MR Q 9-7

8 FIGURE 9.3 A Monopoly Firm in equilibrium earning an economic profit (shaded area) 9-8

9 Table illustrating a monopolist Q TC MC ATC P TR MR

10 Table illustrating a monopolist Q TC MC ATC P TR MR

11 Graph of the same monopolist MC 10 5 ATC D MR -15 Q 9-11

17 FIGURE 9.4 (a) A Monopolist Incurring an Economic Loss 9-17

18 FIGURE 9.4 (b) A Monopolist Earning a Normal Profit 9-18

19 TABLE 9.1 Monopoly Revenue and Cost 9-19

20 FIGURE 9.1 Monopoly Demand and Marginal Revenue 9-20

21 FIGURE 9.2 Monopoly Demand, Marginal Revenue, Average Cost, and Marginal Cost 9-21

22 FIGURE 9.5 Long-Run Equilibrium for the Monopolist 9-22

23 FIGURE 9.6 Monopoly Output Restriction and High Price 9-23

24 Monopolistic Competition Characteristics: Easy Entry and Exit No significant barriers to entry No long term economic profits Large number of firms Firms can be small or large, but not dominant Products are close but not perfect substitutes (product differentiation) Non-price competition (advertising) 9-24

25 Entry and Exit in Monopolistic Competition Economic profits encourage more firms to enter This creates more substitutes for existing brands Decreasing the demand curve for existing firms This process continues until firms earn a normal profit 9-25

26 Monopolistic Competitor Earning an Economic Profit P LMC LAC D P2 More substitutes D shifts down and gets flatter D2 MR MR2 Starts out touching D and intersects MC directly below the tangency point. MR2 Q 9-26

27 Economic losses cause firms to exit This means fewer substitutes for remaining products Increasing the demand curve for remaining firms This process continues until firms earn a normal profit 9-27

28 Monopolistic Competitor with an Economic Loss P LMC LAC Fewer substitutes D increases and gets steeper D2 D MR2 starts out touching D and intersects MC directly below the tangency point MR MR Q

29 FIGURE 9.7 Demand and Marginal Revenue for a Firm in Monopolistic Competition 9-29

30 FIGURE 9.8 Short-Run Equilibrium for a Firm in Monopolistic Competition 9-30

31 FIGURE 9.9 Long-Run Equilibrium in Monopolistic Competition 9-31

32 FIGURE 9.9 (continued) Long-Run Equilibrium in Monopolistic Competition 9-32

33 FIGURE 9.9 (continued) Long-Run Equilibrium in Monopolistic Competition 9-33

34 OLIGOPOLY Key Characteristics: Substantial Barriers to Entry Dominated by a FEW LARGE FIRMS INTERDEPENDENCE AMONG FIRMS Interdependence generates non-price competition (ads) and potentially INCENTIVES TO COLLUDE, merge 9-34

35 Kinked Demand Curve P Market P D curve if firm raises price and rival firms do not D curve if firm lowers price and rival firms match price cuts D Q Firms avoid raising prices (unless they think their rivals will follow suit. They avoid price cuts for fear of starting a price war. The likely outcome is adopting similar prices, and testing price increases to see if rival firms will follow suit (attempting Price Leadership). 9-35

36 Game Theory illustrates the interdependence of firms, and the incentives they face

37 Payoff matrix showing profits of two firms when both have dominant strategies Giant s Advertising Expenditures Low Expenditures High Expenditures Weis Advertising Expenditures Low Expenditures High Expenditures Weis Profits: $300,000 Giant Profits: $300,000 Weis Profits: $400,000 Giant Profits: $100,000 Weis Profits: $100,000 Giant Profits: $400,000 Weis Profits: $200,000 Giant Profits: $200,000 A dominant strategy exists if profits are higher no matter when the rival does. Both Weis and Giant have a dominant strategy: High Ad Expenditures. In this case, an equilibrium solution occurs in the lower right hand cell of the payoff matrix. 9-37

38 Determining a Dominant Strategy Giant s Advertising Expenditures Low Expenditures High Expenditures Weis Advertising Expenditures Low Expenditures High Expenditures Weis Profits: $300,000 Giant Profits: $300,000 Weis Profits: $400,000 Giant Profits: $100,000 Weis Profits: $100,000 Giant Profits: $400,000 Weis Profits: $200,000 Giant Profits: $200,000 For Weis, if Giant chooses Low Expenditures, which option should Weis choose? Answer: High Expenditures, b/c $400,000>$200,000 If Giant chooses High Expenditures, Weis should choose High Expenditures, b/c $200,000>$100,000. Weis has a dominant strategy: High Expenditures. 9-38

39 How to solve a payoff matrix Giant s Advertising Expenditures Weis Advertising Expenditures Low Expenditures Low Expenditures Weis Profits: $350,000 Giant Profits: $400,000 High Expenditures Weis Profits: $300,000 Giant Profits: $200,000 High Expenditures Weis Profits: $100,000 Giant Profits: $500,000 Weis Profits: $200,000 Giant Profits: $300,000 Assume one player chooses one option, then determine what the other player should do Do this for all possible options to determine if either player has a dominant strategy or a consistent strategy

40 Giant s Advertising Expenditures Low Expenditures High Expenditures Weis Advertising Expenditures Low Expenditures Giant Profits: $400,000 Giant Profits: $500,000 High Expenditures If Weis chooses Low, what should Giant do to make the most money?

41 Giant s Advertising Expenditures Weis Advertising Expenditures Low Expenditures Low Expenditures Weis Profits: $350,000 Giant Profits: $400,000 High Expenditures Weis Profits: $300,000 Giant Profits: $200,000 High Expenditures Weis Profits: $100,000 Giant Profits: $500,000 Weis Profits: $200,000 Giant Profits: $300,000 If Weis chooses High, what should Giant do to make the most money? If Giant chooses Low, what should Weis do to make the most money? If Giant chooses High, what should Weis do to make the most money?

42 Giant s Advertising Expenditures Weis Advertising Expenditures Low Expenditures Low Expenditures Weis Profits: $350,000 Giant Profits: $400,000 High Expenditures Weis Profits: $300,000 Giant Profits: $200,000 High Expenditures Weis Profits: $100,000 Giant Profits: $500,000 Weis Profits: $200,000 Giant Profits: $300,000 This is a payoff matrix when Giant has a dominant strategy Giant has a dominant strategy because high expenditures optimize profits no matter what decision Weis makes. However, Weis does not have a dominant strategy. If Giant chooses low, Weis will choose low ($350,000>$300,000); if Giant chooses high, Weis will choose high ($200,000> $100,000). The equilibrium solution depends upon the information Weis has about Giant. If Weis knows Giant s dominant strategy, equilibrium solution will be high expenditures for both and profits will be $200,000 for Weis and $300,000 for Giant.

43 Collusion Cartel Sellers join together to control output and/or prices. Illegal in the US. Example 1: OPEC Example 2: Price fixing of Ivy League Schools Example 3: Coke and Pepsi agreement on which product would be on sale which week of the year Price Leadership Market leader establishes the price, other firms follow suit. Conscious parallelism Firms adopt identical prices without communication. 9-43

44 FIGURE 9.10 Oligopoly Pricing and Output with Economies of Scale 9-44

45 FIGURE 9.11 A Cartel to Ensure Oligopoly Profits 9-45

46 FIGURE 9.12 Sample Payoff Matrix 9-46

47 TABLE 9.2 Share of Value of Shipments Accounted for by the Largest Companies in Selected High- Concentration Manufacturing Industries,

48 TABLE 9.2 (continued) Share of Value of Shipments Accounted for by the Largest Companies in Selected High-Concentration Manufacturing Industries,

49 TABLE 9.3 Share of Value of Shipments Accounted for by the Largest Companies in Selected Low- Concentration Manufacturing Industries,

50 TABLE 9.4 Concentration Ratios for Selected Non-manufacturing Industries 9-50

51 TABLE 9.4 (continued) Concentration Ratios for Selected Non-manufacturing Industries 9-51

52 9-52

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