Chapter 7

Calculating economic profit or loss

(P-ATC) x Output

Explaining each box in the payoff matrix

(think of Z as $) in box 3: USL with a low-price strategy makes 70 million Zs, and IST with a high-price strategy makes 10 million Zs. The reason why the low-price fi rm makes much higher profits is that by charging a low price it captures a large portion of sales from its rival. in box 1: Firms decide to collude and both move to the high price strategy in box 4 Dilemma: IST realises that if it sticks to its agreement it will continue to earn 40million along with USL. The realise that by breaking the agreement and going to the low price strategy they can earn 70mill while USL earns only 10. IST would be better off in the initial condition of 20 mill each. IST has to try 'outguess' USL. it is likely to cut its price to beat USL to the higher profits, but since USL is thinking along exactly the same lines, they are both likely to adopt the low-price strategy, in which case they will end up in box 1 where they both have low prices and low profits. This is the Nash equilibrium, in which both firms become worse off.

Advantages and disadvantages of advertising: The following arguments suggest that advertising can increase efficiency:

- Advertising provides consumers with information about alternative products; it makes it easier for consumers to search for the product that is best suited to their needs, and therefore reduces time and effort wasted on searching for alternative products. - Advertising by rival firms increases competition between them, and therefore contributes to decreasing their monopoly power. - Advertising facilitates introduction of new products by providing information to consumers; in this way, competition (non-price) increases between firms. - By facilitating the introduction of new products, advertising can help lower barriers to entry of new firms into an industry. - By facilitating the introduction of new products, advertising can also provide firms with an extra incentive to engage in research and development for the development of new products.

Evaluating perfect competition -Insights provided by the model

- Allocative efficiency - Productive efficiency -Low prices for consumers -Competition leads to the closing down of inefficient producers. -The market responds to consumer tastes -The market responds to changes in technology or resource prices.

Evaluating perfect competition -Insights provided by the model - w explanation

- Allocative efficiency - Perfect competition leads to the best or 'optimal' allocation of resources based on the mix of goods and services that consumers mostly want, achieved through P = MC in long-run equilibrium. - Productive efficiency -Perfect competition also leads to production at the lowest possible cost, avoiding waste in the use of resources, achieved through production at minimum ATC. -Low prices for consumers - production is at lowest cost, no economic profits in the long run therefore low price. -Competition leads to the closing down of inefficient producers - Inefficient firms produce at higher than necessary costs. They make a loss and therefore exist the industry in the long run. -The market responds to consumer tastes - this shifts demand and changes price. This causes short run profits/losses. In the long run price adjusts. -The market responds to changes in technology or resource prices - Cost curves will shift up or down, leading to profit/loss and more firms entering/leaving. This results in price adjustment in the long run.

Changes demand

- Changes in demand cause movement to a new long run equilibrium E.g. changes in taste -When demand increases, price rises, profits rise, more people are attracted to the industry raising supply, bringing profit back to normal profit

Advantages and disadvantages of advertising: The following arguments suggest that advertising can lower efficiency

- Huge sums spent on advertising by large oligopolistic firms can create barriers to the entry of new firms that cannot match such expenditures. -Advertising increases costs of production and means higher prices for consumers. - Successful advertising increases a firm's monopoly power. -Consumers may become confused and misled about product quality, and may pay higher prices for inferior products. -Advertising may create needs that consumers would not otherwise have, resulting in a waste of resources as consumers buy goods and services they would not have wanted if they were not influenced by advertising.

Non-collusive oligopoly: the kinked demand curve

- In the real world, prices of oligopolistic industries tend to be rigid or 'sticky' (dont change much over time) -in situations when prices do change, they tend to change together for all the firms in an industry -Price rigidities also happen in non-collusive oligopoly, where oligopolistic firms do not agree, whether formally or informally, to fix prices or collaborate in some way. -Kinked demand curve explains price rigidities of oligopolistic firms that do not collude -Instead of agreeing on how to fix prices, their pricing behaviour is strategic, and is strongly influenced by their expectations of how rival firms will react if they undertake a price change. -Corresponding to the kinked demand curve is a broken marginal revenue curve; - -The break in MR occurs exactly at the point of the kink in the demand curve, and is a reflection of the abrupt drop in marginal revenue at the point where the demand curve suddenly bends.

Conflicting incentives

- Incentive to collude - . By colluding to limit competition, they reduce uncertainties resulting from not knowing how rivals will behave, and maximise profits for the industry as a whole. -Incentive to compete - at the same time, each firm faces an incentive to compete with its rivals in the hope that it will capture a portion of its rivals' market shares and profits, thereby increasing profits at the expense of other firms.

Conditions for price discrimination - The price-discriminating firm must have some market power/ability to control price

- Means it must face a downward-sloping demand curve. -Price discrimination can therefore occur in all market structures except perfect competition. -e.g natural monopoly electricity companies often charge lower prices at night than during the day for consumption of electricity -e.g. oligopolistic as a rule charge higher fares during peak travel seasons such as during summer months -e.g. monopolistic firms like cinemas charge kids different amounts and may have discounts on certain days -Perfectly competitive firm would lose customers if they had price discrimination ( sold at a price different to the price determined in the market). Would have no reason to lower price sometimes since it can sell the same amount at the higher price

advertising

- Oligopolies engage heavily in advertising as part of non-price competition. -The only other market structure where advertising figures prominently is monopolistic competition, where firms also engage in non-price competition. -Firms in perfect competition obviously do not advertise, as they produce a homogeneous product, whereas in monopoly there is no need for advertising as the monopolist is the sole producer. Economists disagree on the efficiency aspects of advertising. Some of the points contradict each other. It is possible that different circumstances give rise to different (positive or negative) results.

Explaining oligopolistic behaviour by use of game theory: Prisoners dilemma

- Shows how two rational decision makers, who use strategic behaviour to maximise profits by trying to guess the rival's behaviour, may end up being collectively worse off. -The final position that results from the game is called a Nash equilibrium. Suppose there are two oligopolistic firms in the space travel industry: Intergalactic Space Travel (IST) and Universal Space Line (USL). Each fi rm must decide on a pricing strategy, i.e. what price to charge consumers for its space travel services, and can choose either a high-price or a low-price strategy. Each firm is interested in making its own profit as large as possible, but its profit will depend on the particular combination of pricing strategies that the two firms choose. this figure, a 'payoff matrix' shows four possible combinations of pricing strategies and their corresponding profit outcomes (called 'payoffs') for the two firms

Conditions for price discrimination

- The price-discriminating firm must have some market power/ability to control price - Means it it must face a downward-sloping demand curve. Price discrimination can therefore occur in all market structures except perfect competition. e.g natural monopoly electricity companies often charge lower prices at night than during the day for consumption of electricity -Separation of consumers into groups to avoid the possibility of resale -Different price elasticities of demand

Monopolistic competition: Assumptions of the model

- There is a large number of firms - each firm has a small share of the market and acts independently from others -There are no barriers to entry and exit. -There is product differentiation - biggest diff to perfect comp. differences such as physical, quality, location, service (e.g. home delivery, warranty), product image (may have celebs advertise)

Concentration ratio

- an indication of the percentage of output produced by the largest firms in an industry. -e.g. we could say that the 3-firm concentration ratio of industry X is 78%, which means that the three largest firms of industry X produce 78% of the industry's total output; or the 4-firm concentration ratio of industry Y is 45%, which means that the four largest firms in industry Y produce 45% of the industry's total output - used to provide an indication of the degree of competition in an industry. They suggest that the higher the concentration ratio, the lower the degree of competition. - In general, an industry is considered to be oligopolistic if the four largest firms control 40% of output.

Oligopoly - Why is non price competition very in oligopoly

- considerable financial resources (due to large profits) that they can devote to both R&D and advertising and branding. Whereas monopolistically competitive firms also engage in non-price competition, their resources for these purposes are generally not as large. - The development of new products provides firms with a competitive edge; they increase their monopoly power, demand for the firm's product becomes less elastic, and successful products give rise to opportunities for substantially increased sales and profits. -Product differentiation can increase a firm's profit without risk of retaliation. Takes time and resources for rival firms to develop new competitive products. Cannot be quickly matched like price cuts.

Legislation to reduce monopoly power-Difficulties of legislation to protect competition

- difficulties in interpreting the legislation, what behaviour is allowed and not?. Different views on what actions involve anti-competitive behaviour. -The laws themselves may be vague, allowing much room for different interpretations. -Some countries enforce laws more strictly than others, depending on their priorities or their political and ideologicalviews. -Not all govs accept that government intervention in the market (strict enforcement of competition policies) is necessary to protect consumers against monopolistic practices and to achieve allocative efficiency. Some disagree because over long periods of time, the market and competitive forces on their own accomplish these functions. -There is no 'right' or 'wrong' answer to this issue, as it depends on normative ideas about the economy -Difficult to know if firms are colluding and come up w evidence

Strategic behaviour

- plans of action that take into account rivals' possible courses of action -think in terms of chess- you make a move thinking about the move the opponent is able to make as a consequence of your move -Guess the reactions of their competitors when making their decisions

Calculating short-run shut-down and break-even prices

- short-run shut-down price =AR= MR = min AVC -break-even price = AR= MR = min ATC

Legislation to reduce monopoly power-Legislation in the case of mergers

-A merger is an agreement between two or more firms to join together and become a single firm. -Mergers occur for various reasons such as: such as an interest in capturing economies of scale , or an interest in firm growth , or interest in acquiring monopoly power -Mergers are an issue in competition policy because they may allow firms to gain too much monopoly power when they become bigger -Legislation usually involves limits on the size of the combined firms. Difficulties with merger policies include: -questions and uncertainties about what firms should and should not be allowed to merge, -issues of interpreting the legislation -Ideological differences among different governments on the desirability or not of a high degree of monopoly power (as in the case of competition policies).

Third-degree price discrimination 3 - profit-maximisation

-Assume there are two consumer groups (or two markets) for product X, distinguished from each other on the basis of differing PEDs. Part (a) shows the consumer group of market 1 to have a relatively inelastic demand (low PED), while part (b) shows the consumer group of market 2 to have a relatively elastic demand (high PED). The two marginal revenue curves are added horizontally, leading the total market marginal revenue curve in part (c), which also shows the firm's marginal cost curve To maximise profit, MR=MC, thus finding the profit-maximising level of output Q3. Output Q3 must now be divided between the two markets. The firm does this by equating its MC of the total market with the MR of each individual market: MC = MR = MR1 = MR2. This determines output level Q1 in market 1, sold at price P1 (given by the demand curve D1), and output level Q2 in market 2, sold at price P2 (given by the demand curve D2). (Note that Q1 + Q2 = Q3.) Figure 7.26 shows that the firm will charge: -a higher price (P1) for the consumer group with relatively inelastic demand -a lower price (P2) for the consumer group with relatively elastic demand. Third-degree price discrimination results in higher revenues and profits for fi rms.9 If profits did not increase, firms would not practise price discrimination

Open/formal collusion: cartels

-Cartel - a formal agreement between firms in an industry to take actions to limit competition in order to increase profits it therefore involves formal collusion (or open collusion). The agreement may involve: - Limiting/fixing the quantity each firm produces. Results in increasing the price - Fixing price -Restricting nonprice competition (e.g. advertising) -dividing the market according to geographical or other factors - agreeing to set up barriers to entry objective: to limit competition, increase the monopoly power of the firms, and increase profits.

Changes in technology or resource prices

-Causes a fall in resource prices and improved technology for production -These changes lower the firms cost curves leading to supernormal profit -More suppliers are attracted to the industry bringing it back to normal profit -Industry output increases and the final price is lower -Fall in price is equal to the fall in minimum ATC

Collusive oligopoly

-Collusion in oligopoly refers to an agreement between firms to limit competition, increase monopoly power and increase profits. illegal in most countries, because it works to limit competition. -Most commonly involve price fixing agreements -May be done formally, a cartel, or informally, such as price leadership.

Third-degree price discrimination 1

-Common type of discriminations, based on the principle that different consumer groups have different price elasticities of demand for a product. -Also known as 'discrimination among consumer groups' -Lower prices for people with high PED, higher price to those with low PED examples: -cinemas, museums charge lower rates to children -airlines charge higher prices for business travellers than for leisure travellers and cheaper if tickets are bought in advance -Restaurants may have discounts on specific days -hotels are cheaper in some seasons -phone rates cheaper on weekends -hairdressers and drycleaners may charge higher prices for women -bars may offer lower prices for a short period immediately after working hours -bars may offer lower prices for a short period immediately after working hours

Conditions for price discrimination - Separation of consumers into groups to avoid the possibility of resale

-Consumers must be separated from each other on the basis of some characteristic, such as time, geography, age, gender, technology, income or other factors. -Firms differentiate their prices on the basis of these characteristics. -e.g. cinemas and hotels often charge lower prices to older people and children (consumer separation by age); telephone companies sometimes offer lower rates for evening or weekend calls (consumer separation by time) -The price-discriminating fi rm must ensure that it is not possible (or is hard and costly) for any consumer to buy at the low price and resell at the higher price. -In some cases, resale is impossible due to the nature of the product, especially where services are involved, such as in the case of medical services, legal services and education

There are two factors at work making for a natural monopoly:

-Costs and market demand D, intersects the LRATC curve, LRATC curve is still declining meaning that economies of scale have not yet been fully exhausted and the minimum efficient scale occurs at a higher level of output. Minimum efficient scale - lowest level of output at which lowest average total costs are achieved. As output increases, average costs fall, and keep on falling even beyond the point where the entire market demand for the product is satisfied. This means it is extremely difficult for new firms to enter because monopoly firm is able to satisfy all the demand at the lowest price.

Concentration ratios have several weaknesses that limit their usefulness as a measure of the degree of competition:

-Does not consider firms from abroad who import. -Provide no indication of the importance of firms in the global market -do not account for competition from other industries, which may be important in the case of substitute goods, such as in the case of different metals. -do not distinguish between different possible sizes of the largest firms. For example, a three-firm concentration ratio of 90% could consist of three firms with 30% of the market each, or of three firms, one of which has 60% of the market and the other two have 15% each.

Explaining the kinked demand cruve

-Each firm perceives the demand curve it faces to be elastic for prices above P1 and inelastic for prices below P1. -If one firm raises its price above P1, the others will not follow; if it lowers its price below P1, the others will match the price decrease. In either case, the firm will be worse off. -Therefore, no firm takes the initiative to change its price, and they all remain 'stuck' at point Z for long periods of time.

Benefi ts of oligopoly

-Economies of scale can be achieved -Product development and technological innovations can be pursued due to the large economic (supernormal) profits - This benefit of oligopoly is more important than in the case of monopoly, since non-price competition forces firms to be innovative in order to increase their market share and profits. -Technological innovations that improve efficiency and lower costs of production may be passed to consumers in the form of lower prices Over and above the benefits of oligopoly that are similar to monopoly, oligopoly also offers the following advantage: • Product development leads to increased product variety, thus providing consumers with greater choice (monopoly does not offer product differentiation and variety).

3 important points illustrated by the kinked demand curve

-Firms that do not collude are forced to take into account the actions of their rivals in making pricing decisions (interdependence) Otherwise they risk lowering their revenues and profits, which in turn could lead to price instability. -Even though the firms do not collude, there is still price stability. Firms are reluctant to change their price because of the likely actions of their rivals, which could result in lower profits for the firm initiating price changes. -Firms do not compete with each other on the basis of price. They do not try to increase their sales by attracting customers through lower prices. A lower price not only invites price cuts by rivals, with resulting lower profits for all the firms, but also risks setting off a price war if some firms overreact with price cutting.

Explaining the kinked demand curve

-Imagine three firms, A, B, and C, each producing output Q1 and selling it at price P1; this price-quantity combination is point Z at the kink of the demand curve. why does the demand curve facing them have the kink? Firm A considers a price change, but before changing its price, it tries to predict how firms B and C will react. Firm A's reasoning is as follows: -If A raises price, what will • B and C do? They are unlikely to increase their price, because if they continue to sell at P1, many of my customers will leave me and start buying from B and C. Therefore, B's and C's market share will increase, and A will fall. I should therefore not increase my price. A demand curve is relatively elastic above P1, and A profits may fall (though not all customers will leave me because of differentiated product). -If A drop price, what will B and C do? They are likely to drop their price as well, because if they do not, A will capture a large portion of their sales, and will be better off at their expense. But if they drop their price, A will capture only a small part of their market shares. A's demand curve is relatively inelastic below P1, because for any price decrease A will have only a small increase in sales and revenues, and profits may fall. A should therefore not drop my price. -A should therefore not change my price, and should continue selling at P1.

Obstacles to forming and maintaining cartels 1

-Incentive to cheat - firms may secretly offer lower price or other concessions to customers increasing their profits at the expense of the other firms. If cheating is discovered it puts the cartel in danger of collapse -Cost differences between firms-different firms have different costs. Output will not equate to every firms MC=MR profit maximising output. Difficult to agree where to set the price and how much each firms produces. -Firms face different demand curves -due to different market shares and product differentiation, making agreeing on common price difficult. -Number of firms - more firms, more difficult to agree on price and output allocation. -Possibility of a price war -possible outcome of one or more firms cheating on the cartel agreement. Other firms will retaliate and go lower and they will all be worse off

Another type of informal collusion

-Informal agreements -Firms agree to use a rule for co-ordinating prices such as limit pricing -limit pricing - firms informally agree to set a price that is lower than the profit-maximising price, thus earning less than the highest possible profits and so discouraging new firms from entering the industry. With limit pricing, firms may end up sacrificing some profit in order to avoid attracting new firms into the industry.

Profit maximisation by the monopolist: when do they continue producing?

-Just as in perfect competition, the loss-making monopolist continues to produce in the short run as long as its losses are smaller than its fixed costs (P > minimum AVC). -In the long run (when all resources are variable), the loss-making monopolist is likely to shut down or move its resources to another more profitable industry. -Distinction between long and short run is not as big in monopoly as in perfect competition. -In perfect competition, the distinction between the short and long runs is of crucial importance because as firms enter and exit an industry in the long run, economic (supernormal) profits and losses disappear, and firms are left with normal profits in their long-run equilibrium. This is not possible in monopoly, due to the presence of barriers to entry.

Legislation to reduce monopoly power

-Legislation to protect competition -Legislation in the case of mergers

Comparison of Monopolistic competition and monopoly 2

-Market power - Monopoly has more power because no substitutes -Allocative and productive efficiency - Both face downward-sloping demand curves, and therefore both have MR curves that lie below the demand curve. This means that at the profit-maximising level of output (found by MR = MC), P > MC for both (i.e. no allocative efficiency). Also, ATC is higher than minimum ATC at the point of production for both (i.e. no productive efficiency). -Competition and costs - More firms in monopolistic comp causes downward pressure on price, and inefficient producers leave. No price pressure for monopoly. -Economies of scale - much greater potential for monopoly -Research and development - monopoly can earn profit in the long run to fun R&D. Pressures of competition faced by monopolistically competitive firms may induce them to pursue R&D for product development in order to maintain/increase their sales.

Criticisms of oligopoly

-Neither productive nor allocative efficiency is achieved. -Higher prices are charged and lower quantities of output are produced than under competitive conditions. -There may be higher production costs due to lack of price competition (X-inefficiency). -In addition, there is a further argument against oligopoly: • Whereas many countries have anti-monopoly legislation that protects against the abuse of monopoly power, the difficulties of detecting and proving collusion among oligopolistic firms means that such firms may actually behave like monopolies by colluding and yet may get away with it.

Comparison of Monopolistic competition and monopoly 1

-No. producers - monopoly is a single firm -Size of firms - in monopolistic comp, many small firms. Monopoly is one big firm. -Barriers to entry. - Monopolistic competition is characterised by free entry and exit, whereas in monopoly there are high barriers to entry. -Normal and economic profits - monopoly can earn economic (supernormal) profits due to high barriers to entry that prevent new entrants from entering the industry. -Competition and prices - Free entry and exit under monopolistic competition drive economic profits down to zero in the long run, and allow prices to be lower for the consumer than is possible under monopoly, where barriers to entry allow the firm to maintain profits over the long run.

Comparison of Monopolistic competition and perfect competition

-Number of firms - Both structures are similar if they have a large number of firms -Free and entry and exit -both structures -Normal profit in the long run, supernormal profit or loss in the short run - both structures -Market power and the demand curve - perfect comp has no power, they take the market price. Perfectly elastic D curve. monopolistic competition have some power, hence the sloping D -Productive and allocative efficiency - perfectly competitive firm achieves both in the long run. monopolistically competitive firm achieves neither Production is not at minimum ATC, consumers pay more. MB>MC -Excess capacity - monopolistic competition produces a lower level of output than that where ATC is minimum, and therefore has excess capacity -Product variety-in perfect competition produce the identical product, under monopolistic competition firms go to great lengths to differentiate their products. -Economies of scale - Firms in perfect competition cannot achieve economies of scale because they are very small. Firms in monopolistic competition may have some small room for achieving economies of scale but only to a relatively small degree as these firms also tend to be relatively small.

The role of non-price competition in oligopoly

-Oligopolistic firms go to great lengths to avoid price competition (unlike monopolistic comp). -Careful not to trigger a price war because this makes all firms worse of - lower price, lower profit. - A price war may even lead to prices lower than average costs, leading to losses for the firms. Firms in oligopoly are better off co-ordinating their pricing behaviour where they can, and when they do not collude they still avoid competitive price-cutting. -Usually engage in non-price competition, involving efforts by firms to increase market share by methods such as advertising and branding

What if P is not equal to MC? - allocative inefficiency

-P > MC, an additional unit of the good is worth more to consumers than its costs to produce. Underallocation of resources to production, and consumers would be better off if more of it were produced. - P < MC, an additional unit of the good costs more to produce than it is worth to consumers; Overallocation of resources to the good, and consumers would be better off if output were reduced.

Allocative inefficiency: loss of consumer and producer surplus (monopoly) *

-Perfectly competitive = allocative efficiency shown by MB = MC and maximum social surplus, monopoly does not. Consumer Surplus: Perfect Comp (A) > monopoly (C). - In monopoly part of A = producer surplus due to higher monopoly price. (D) - In monopoly part was lost (Part E) = welfare loss because quantity supplied is lower than what is demanded at market equilibrium. In Monopoly: - Producer surplus has also fallen by part F (welfare loss) due to the lower quantity being sold -E + F represents loss of social benefits (consumer and producer surplus) due to monopoly's higher price and lower quantity. Qm, MB>MC (underallocation)

Why a monopoly may be desirable

-Product development and technological innovation (economies of scale, protected, R&D) -Possibility of greater efficiency and lower prices due to technological innovations -Economies of scale (falling av costs over large range of output = lower prices + increased quantity + more efficient) cons, society

Obstacles to forming and maintaining cartels 2

-Recessions-during recession firms have a stronger incentive to lower prices and cheat on the agreement, endangering the survival of the cartel -Potential entry into the industry -If cartel is successful, it will make large economic profits, encouraging entry of new firms into the industry. New entrants, increased supply, lowered price and profit. The cartel's long-run survival therefore depends on high barriers to entry that block potential new entrants. -The industry lacks a dominant firm- A dominant is like a leader and helps form the agreement. e.g. in OPEC, the dominant member of the cartel is Saudi Arabia, which is also the largest producer of oil among all the members. The lack of a dominant firm makes agreement among the cartel members more difficult to reach.

Barriers to entry: Economies of scale

-Results in a downward sloping curve of a firms LRATC permitting lower average costs as the firm grows in size - Barrier to entry exists when economies of scale are extensive. LRATC declines over a very large range of output. - SRATC of a large firm (SRATC1) sits much lower than a small firm (SRATC2) -Large firm can lower costs, forcing smaller firms to sell at a price where they cant cover costs. This means new small firms cant enter the industry because they cannot compete with the large one. -Entering an industry on a large scale however would require huge start up costs.

Mutual interdependence has important implications for the behaviour of oligopolistic firms:

-Strategic behaviour -Conflicting incentives

This game illustrates many real-world aspects of oligopolistic firms

-Strategy interdependence - display strategic behaviour - actions based on what their rivals are likely to do -face conflicting incentives - incentive to collude and compete -become worse off as a result of price competition - price war -have a strong interest in avoiding price wars, because they realise that everyone will become worse off through price cutting - this creates a strong incentive for them to compete on the basis of factors other than price (non-price competition).

Third-degree price discrimination 2

-The condition that makes this kind of price discrimination profitable for a firm is that each consumer group must have a different PED -e.g. business travellers' demand for airline tickets is relatively inelastic (low PED), and therefore airline tickets are often more expensive if there is no stay-over on a Saturday night (on the assumption that business travellers are usually unwilling to stay overnight on a Saturday). -Children and elderly people have a more elastic demand (higher PED) for movies, transport etc. and are therefore charged a lower price -The firm's profit-maximising strategy in third-degree price discrimination is illustrated in Figure 7.26

Perfect competition is based on the following assumptions

-There is a large number of firms (small output compared to size of market - independent) -All firms produce identical or homogenous products -There is free entry and exit -There is perfect (complete) information. (same info - lowest cost (cons + prod)) -There is perfect resource mobility. (transferred easily) Some industries meet these assumptions more than others.

Assumption of an oligopoly

-There is a small number of large firms. -There are high barriers to entry - same as monopoly due to things like economies of scale -Products produced by oligopolistic firms may be differentiated or homogeneous -There is mutual interdependence-decisions taken by one firm affect other firms in the industry. If any one firm changes its behaviour, this can have a major impact on the demand curve facing the other firms. Therefore, firms are keenly aware of the actions of their rivals.

Evaluating perfect competition -Limitations of the model w explanation

-Unrealistic assumptions. -Limited possibilities to take advantage of economies of scale -In perfect competition the requirement that the firms are many and small prevents them from growing to a size large enough to take advantage of economies of scale. -Lack of product variety - homogenous products are a disadvantage for consumers who like variety -Waste of resources in the process of long-run adjustment -the model unrealistically assumes there are no costs of adjustment. When people continually enter and leave, resources are wasted - Limited ability to engage in research and development -The lack of economic profits in the long run does not offer firms the necessary funds to pursue research and development -Market failure-there are numerous real-world situations where resources are allocated inefficiently because of market failures

Evaluating perfect competition -Limitations of the model

-Unrealistic assumptions. -Limited possibilities to take advantage of economies of scale. -Lack of product variety. -Waste of resources in the process of long-run adjustment. - Limited ability to engage in research and development. -Market failure.

Price discrimination -The single-price firm versus the price discriminating firm

-firms often find that they can increase their profits by selling their product at different prices. -Price discrimination is the practice of charging a different price for the same product to different consumers when the price difference is not justified by differences in costs of production. (If price differences are due to differences in a firm's costs of production, then they do not qualify as 'price discrimination'.)

Profit maximisation by the monopolist: Profit maximisation based on the marginal revenue and cost approach

-same three-step approach used by the perfectly competitive firm 1) profit-maximising (or loss-minimising) level output using the MC = MR rule. 2)For that level of output, it determines profit per unit or loss per unit by using profit/Q=P −AT The diagrams show the standard ATC and MC curves as well as the monopolist demand and marginal revenue curves a) firm maximising profit: a line is drawn upward from where the MR=MC point = the D curve which is at the profit maximising level of output. b) firm minimising loss: a line is drawn upward from where the MR=MC point = the D curve which is at the loss minimising level of output.

industry

A group of one or more fi rms producing identical or similar products is called an industry

monopoly

A market in which there are many buyers but only one seller. Complete control of a product or business by one person or group Pure monopoly: When there is a single firm producing a good or service for the entire market, it is called a pure monopoly. - single seller/dominant firm in market - no close substitutes - significant barriers to entry (no comp + substantial market power)

collusion

Agreement between firms to limit competition between them, usually by fixing price and therefore lowering quantity produced

Allocative inefficiency: P > MC *

Allocative efficiency: P=MC -P > MC is the same as MB > MC (since P = MB), therefore monopoly does not achieve allocative efficiency, but perfect competition does Underallocation

Allocative and productive inefficiency

Allocative inefficiency: loss of consumer and producer surplus Allocative inefficiency: P > MC Productive inefficiency: production at higher than minimum ATC

Moving from short-run equilibrium to long-run equilibrium: Economic (supernormal) profit in the short run to normal profit in the long run

Assume that a perfectly competitive industry is in short-run equilibrium where each firm in the industry is earning economic (supernormal) profit Initial industry equilibrium in show in diagram b at 1. At this price, MC= MR at Q1 and as shown on diagram a, the firm earns supernormal profit. One the firm is in the long run, there is free entry and exit so more firms are attracted to the industry shifting supply to S2. This reduced price to break-even price and firms earn normal profit again.

When the loss-making firm exits the market in the long run

Break-even price (SR) = the shut-down price (LR) LR: any loss-making firm facing a price lower than minimum ATC will shut down and leave the industry.

The firms revenue curves

Consider perfectly competitive firm: - Sells at $10 -Unable to change the market determined price. No matter how much output the perfectly competitive firm sells, P = MR = AR (constant at horizontal D curve) From - Price is constant regardless of the level of output sold.

Conditions for price discrimination - Different price elasticities of demand

Consumers must have different price elasticities of demand (PEDs) for the good. This is because consumers with a relatively low PED will be willing to pay a higher price for a good than consumers with a relatively lower PED. This will become clearer in the discussion that follows.

The demand curve (average revenue curve) facing the firm

Diagram a: equilibrium of demand and supply of entire industry. All firms sell: Pe. Digram b: Demand = Perfectly elastic (horizontal) at the price determined in the market for that good. Firm is a price-taker: accepts the price determined in the market. No limit to how much is demanded at this price.

Monopoly market outcomes and efficiency - Higher price and lower output by the monopolist compared to the industry in perfect competition

Diagrams show the long run situation of a perfectly competitive industry vs a monopoly -Price is higher and quantity of output produced lower in monopoly. -For the monopoly MR lies below D, where as perfectly competitive firm MR = D

oligopoly examples

Differentiated: Airline Industry Pharmaceuticals Smart Phone and Computer Operating Systems Homogeneous: Oil Cement

Tacit/informal collusion: price leadership and other approaches

Difficulties involved in making and maintaining cartels, such as their illegality can result in informal collusion. -Tacit collusion (or informal collusion)- cooperation that is implicit or understood between the co-operating firms, without a formal agreement. -objectives - co-ordinate prices, avoid competitive price-cutting, limit competition, reduce uncertainties and increase profits. Also attempts to bypass the obstacles created by the illegality of formal collusion (cartels).

Barriers to entry:

Economies of scale Branding (ad to influence consumer tastes in favour of the product and establish consumer loyalty) Legal Barriers (Patents - sole producer right from govt for developing, Copyrights, tariff, licence) esp. pharmaceuticals Control of essential resources (can own them, long-term contracts with the best players and securing exclusive use of sports stadiums) Aggressive tactics (cutting its own price, advertising aggressively, threatening a takeover of the potential entrant)

natural monopoly *

Economies of scale so large that SINGLE FIRM ALONE SUPPLY ENTIRE MARKET AT LOWER AV COST than two or more firms. A natural monopoly is illustrated in Figure 7.13. Market demand for a product is within the range of falling LRATC

Natural monopoly examples

Examples of natural monopolies include water, gas and electricity distribution, cable television, fire protection and postal services.

Productive inefficiency, product differentiation and excess capacity (Monopolistic competition)

Firm's capacity output = output at min ATC - capacity fully used EXCESS CAPACITY: difference between capacity output and profit-maximising output - amount of output that is lost when firms underuse their resources and produce an amount that does not minimise ATC From: + product differentiation (downward D curve) (need horizontal D curve for min ATC) (cannot just lower price for extra capacity - people expect prices to go down)

Key objective of a cartel

Firms can gain monopoly power and increased profits. However, cartels are illegal in most countries, as they restrict competition and are therefore against consumers' and society's best interests.

Regulation of natural monopoly- Marginal cost pricing *

Force firm to produce at P=MC where they would achieve allocative efficiency This is called marginal cost pricing, where intersection of D or AR and MC gives rise to price Pmc and to quantity Qmc. Qmc = larger quantity at Lower P Pros: Forces efficient allocation of resources, and quantity of the good produced increases to the socially desirable level. Cons: Natural monopolist loses - Pmc lies below the ATC curve at the point of production, = P is too low to cover av cost - force monopolist to shut down in LR (when D cuts ATC left of min ATC, MC cannot be above ATC)

Regulation of natural monopoly -average cost pricing Pt 1

Forced to charge P = ATC Occurs where D intersects ATC at point e. = higher price and lower quantity than marginal cost pricing,= not as efficient as MC pricing - no productive efficiency (not at min ATC) a. Monopolist is forced to earn normal profit b. more efficient than market solution Disadv: - guaranteed price = av cost = lose incentive to produce at min cost and maximise profit (even if av. costs go up, still receive price covering costs) -continued regulation = protection to firm from new competitors that may have been more efficient

Elements of competition and monopoly

Has elements of both competition and monopoly Like perfect comp because there are many firms in the industry and there is freedom of entry and exit. like monopoly because of product differentiation Each firm in an industry is a 'mini monopoly' in the specific version of the good that it produces. For example, Adidas is a monopoly in Adidas® shoes, NIKE is a monopoly in NIKE® shoes Downward sloping curve for their good, however it is relatively elastic because these shoe brands are substitutes for eachother. more elastic than in monopoly, but less elastic.

Normal profit in the long run - monopolistic competition diagram

In the short run, there may be profit and loss but this causes firms to enter or leave the market, returning firms to normal profit. (When D is tangent to ATC) MR = MC, P = ATC economic profit is zero and each firm is earning normal profit.

Profit maximisation in the long run (perf comp)

LR - resources variable: -Firms enter/leave and grow/shrink their business All perfect comp: - earn normal profit.

MC = P

MC = opportunity cost of the resources used to produce one extra unit of the good.

allocative efficiency

MC=MB Social surplus is at a max. - Equality between what consumers are prepared to pay to get one more unit and what it costs to produce it. Allocative efficiency: when firms produce the particular combination of goods and services that consumers mostly prefer. The condition is the following: Allocative efficiency is achieved when P = MC. Also no externalities: (MSB=MSC)

The monopolist's revenue curve continued

MR<D because unlike perfect comp when MR = P, the firm must lower price to sell more output. The lower price is charged not only for the last unit of output but all the previous units of output sold. Even the people who were willing to pay the higher price get to pay the lower price when the price is lowered MR or extra R from more output = amount of the price of the last unit sold minus what is lost by selling all the other units of output at the now lower price. (in basic words: everyone gets to pay the lower price, not just the additional people who demanded the good after the price fall)

Loss minimisation in the short run

Market price falls below minimum ATC and the firm does not earn enough revenue to cover all costs. The firm is making negative profit. This is the point where MC=MR therefore, Q3 is the firm's loss-minimising output. ATC - P3, (or the diff between c and d) represents the loss per unit output.

Short-run profit maximisation based on the marginal revenue and marginal cost rule

Maximise profit produces at where MR=MC OR Maximise where: AR - AC = profit

Legislation to reduce monopoly power-Legislation to protect competition

Most countries have laws that try to promote competition by preventing collusion between oligopolistic firms in order to: -restrict competition between them -to prevent anti-competitive behaviour by a single firm that dominates a market. The objective of the legislation: to prevent monopolistic behaviour, thus promoting allocative efficiency A well-known example of a single firm accused of anti-competitive behaviour is Microsoft, found guilty of restricting consumer choice and preventing competitor firms from selling operating systems, thus maintaining its operating systems monopoly. Firms that are found guilty of anticompetitive behaviour are usually asked to pay fines (as in the case of Microsoft), or may be broken up into smaller firms.

Why would a firm continue running if they are earning negative profit? In Short Run

Need to sell to make some money to cover the cost of fixed inputs. Because this is only in the short run when costs are fixed, in the long run they may be able to earn normal or supernormal profit. if the firm stops producing at this point their loss is equal to their fixed costs. When ATC > P > AVC loss is smaller than its fixed cost

Efficiency in monopolistic competition: Allocative and productive inefficiency

Neither allocative or productive efficiency is reached. - Allocative efficiency- P = MC - Productive efficiency - production takes place at minimum ATC Comparing P and MC: - At Qe, price > MC = underallocation - greater than min ATC = cost is higher than optimal (society)

Efficiency and perfect competition in the short run

Neither the profit-making nor the loss making firm achieves productive efficiency in the short run, because ATC is higher than minimum ATC at the level of output where they produce. Only if the firm is in diagram b earning normal profit will it be productively efficient. This is because short run equilibrium is equal to long run equilibrium. SR: ALLOCATIVE EFFICIENCY not always Productive Efficiency

Non price competition

Non-price competition - when firms use methods other than price reductions to attract customers from rivals. E.g. product differentiation (such as physical and quality differences, packaging, services provision, location, etc.), advertising and branding (creating brand names for products). R&D in product development, advertising and branding More diff = LESS ELASTIC D = increase monopoly power and raise price without a great risk of losing consumers

Explaining the appearance of short-run profits and losses

Once an industry and its firms find themselves in a position of long-run equilibrium, they will remain there indefinitely until something from outside the system causes a disturbance. If a disturbance occurs, firms find themselves in situations making economic profits or losses, as portrayed in Figure 7.6 (a) and (c). What factors could cause disturbances? -Changes demand -Changes in technology or resource prices

P=MR=AR

Only perfect competition - no control over price they sell at (single price determined in market) This is shown in diagram a where TR increases at a constant rate Diagram b shows that Since price is constant at €10, P = MR = AR, and they all coincide with the horizontal demand curve

the loss-making firm that will not produce

P < AVC If the firm were to keep producing, their loss would be between points c and d, which is greater than the AFC. They will be losing the AFC in addition to the AVC cost that is not covered by revenue. Shut down in the short run, and will make a loss equal to its fixed costs

zero economic profit (normal profit) in the short run and the break-even price

P1 falls to P2. MC=MR thus, Q2 P=ATC and therefore there is zero economic profit. When there is zero economic profit, price = minimum ATC. this is called the break even point. Revenue = Explicit + implicit costs Making a normal profit

loss in the short run and the short-run shut-down price

P= AVC is called shutdown price. If the firm keeps producing, they are only earning revenue to cover variable costs, and the loss is unchanged. Loss per unit = AFC

At the profit maximising level of output Q

P>ATC supernormal profit P=ATC normal profit P<ATC loss

Efficiency and perfect competition in the long run

Part a shows the firm is earning normal profit. This means that in the long run the perfectly competitive firm achieves both allocative and productive efficiency. At the profit-maximising level of output, Qe, P = MC, and ATC is minimum. Part b illustrates how the firms efficiency corresponds to the efficiency at the level of the industry. Pe = MC = MB and consumer and producer surplus is at a max

Lack of competition in monopoly may lead to higher costs (X-inefficiency)

Perfect comp: comp => constant pressure to produce at the lowest possible cost to survive Monopoly: lack of comp => less incentive to lower costs -Higher costs could arise due to: poor management a poorly motivated workforce lack of innovation lack of use of new technologies. X-inefficiency: producing at a higher than necessary ATC

Advantages and disadvantages of monopoly compared with perfect competition

Price and output - monopolist produces a smaller quantity of output and sells it at a higher price than a perfectly competitive industry. Efficiency +: innovation may = efficiency - perf comp = allocative and productive efficiency in LR - perf comp = less likely to display X-inefficiency (constant pressure and comp - monop = no allocative efficiency (P>MC) - monop = no productive efficiency (above min ATC) - monop = lack of com = X-inefficiency Research and development (R&D) - + Perf: no incentive - no econ profits or barriers to entry/copy + Monop: can maintain econ profits in LR = financial ability to R&D + incentive to develop due to protection - Monop: high barriers to entry = no incentive to improve/compete Economies of scale - Perfectly competitive firms are unable to achieve this because they are too small. Monopolies can take advantage of economies of scale, and may use these to create a barrier to entry of new firms (by lowering their costs, thus their prices)

Price competition

Price competition - when a firm lowers its price to attract customers away from rival firms, thus increasing sales at the expense of other firms.

Productive (technical) efficiency

Produce at min ATC Lowest possible cost - Resources are being used economically (not wasted)

Supernormal profit

Revenue - (Explicit + implicit costs)>0 If firms are making economic profit, in a way they are getting free money. This means lots of people may be attracted to the industry. This will increase supply, lowering price until the profit goes back to 0. Profit could go below 0, but since it is easy for firms to leave, they will. Therefore supernormal profit may not last in LR.

Profit maximisation for price-takers in the short run

SR - one or more input is fixed = firms cannot enter/exit industry Can only profit max by = CHANGE OUTPUT - price-taker cannot influence price

The demand curve facing the monopolist vs perfectly competitive firm

Since the pure monopolist is the entire industry = the demand curve it faces is the downward-sloping industry or market demand curve - still limited to point on D curve Perfectly competitive firm faces perfectly elastic demand at the price level determined in the market the perfectly competitive firm is a price-taker with zero market power monopolist is a price-maker with a significant degree of market power. All other firms: downward sloping demand curve, and varying degrees of price changing ability.

Open/formal collusion: cartels - diagram

Suppose the firms of an industry decide to form a cartel by fixing price, we have this diagram. This is the exact same as how the monopolist maximises profit. D and MR are for the entire industry. The MC curve is the sum of all the MC curves of all the firms in the cartel. Profit maximising output of the cartel is found by MR=MC. How do they decide which firm produces how much? One way this can be done is to agree on what share of the market each firm will have based on historical market shares. Another way is that firms may agree to compete with each other for market shares using non-price competition (product differentiation and advertising).

Revenue maximisation by the monopolist: Comparing revenue-maximisation with profit maximisation *

TR = max when MR=0 This shows that the Revenue maximiser produces a greater output at a lower price than the profit maximiser who produces where MR=MC. (Pr and Qr are revenue maximiser values and the other ones are profit maximising values)

Calculating the revenue-maximising level of output

TR is at a max when MR=0 Therefore revenue maximising output is 7

The monopolist's output and price elasticity of demand *

TR is increasing and MR is positive - the demand curve facing the firm (P = AR) is price elastic (PED > 1) TR is falling and MR is negative - PED<1 -When demand is elastic, price and total revenue change in opposite directions. E.g. as price falls from €12 to €6, TR rises -When demand is inelastic, price and total revenue change in the same direction e.g. after €6 where PED<1 (inelastic) -Total revenue is maximum, and MR = 0 where PED = 1. The monopolist will not produce any output in the inelastic portion of its demand curve (which is also its average revenue curve).

Cartel example

The best-known example of a cartel is OPEC (Organization of the Petroleum Exporting Countries), composed of a group of 13 oil-producing countries. OPEC periodically tries to raise the world price of oil by cutting back on its total output. Each member country is assigned an output level (quota) that it is permitted to produce. The restricted quantity of oil results in a higher price.

Productive inefficiency: production at higher than minimum ATC

The condition for productive efficiency is that production takes place at minimum ATC Therefore perfect comp firm is efficient but monopoly is not. At Qm, the monopolist's average total costs (ATC) are higher than minimum ATC; therefore, there is productive inefficiency

Natural monopoly: falling average costs

The falling average costs over a very large range of output often occur because of very large capital costs (such as laying pipes for water distribution, or laying cables for electricity distribution, or putting a satellite into orbit). A natural monopoly may stop being natural if new technologies allow other firms to produce at the lower price. This means that the firm is no longer a natural monopoly because they have to compete with new low cost firms.

Regulation of natural monopoly

The gov can step in to regulate a monopoly by: -Marginal cost pricing -Average cost pricing If there is a natural monopoly, it is not in society's interests to break it up into smaller firms, as this would result in higher average costs and would be inefficient. Thus, govt regulate: the diagram shows a natural monopoly. The demand curve intersects the ATC curve before ATC reaches its minimum, indicating that economies of scale have not been full exhausted. MC=MR at Qm where price is Pm

Economic loss in the short run to normal profit in the long run

The market decides on equilibrium Price P1 and loss minimising quantity is where MC=MR which is at Q1. In the short run firms are unable to leave the industry but in the long run they can. Once firms leave the industry, supply falls, price rises until firms losses = 0 (where P= minimum ATC)

Monopoly and olligopoly - changing the price

The term monopoly power, which refers to the ability of a firm to set prices, applies not only to monopoly, but also to oligopoly. Oligopolistic firms sometimes act together (or 'collude'), usually illegally, to acquire greater monopoly power. If this works, then together they can work as a monopoly. Legislation to reduce monopoly power applies not only to monopolies but also to fi rms that try to behave like monopolies.

what is better about monopolistic competition (than monopoly)

There is incentive to improve the product, where as monopoly has no incentive because no competition product variety

Short-run equilibrium under perfect competition

These short-run firm equilibrium positions for the firm and for the market hold and will continue to hold, ceteris paribus. The reason is that firms in the short run cannot change their fixed resources, and so if nothing else changes (market demand, resource prices, the technology of production, etc.), the firms will continue to produce at the equilibriums in the previous card, earning super normal, normal profit or making a loss

The break even price in the long run

This is the same in the short and long run This point is where P = minimum ATC

The monopolist's revenue curve

When a firm faces a downward-sloping demand curve, price is no longer constant for all output: more output can only be sold at a lower price. -As price falls, quantity rises. TR (QxP) rises until output of 7 units, then falls. -Marginal revenue falls continuously. MR=0 when TR=Maximum. MR become negative when TR falls -AR = P = D

profit maximisation and economic profit in the short run

When a market price is P1, P1=MR1=AR1=D1 The intersection of MC and MR, where MC=MR determines profit maximisation level. Since P1>ATC, the firms profit per unit = P1-ATC. This is represented by the vertical distance between P1 and ATC which is equal to a minus b Total profit is shown by the shaded area When P > ATC at the level of output where MC = MR, the firm earns positive economic profit (supernormal profit).

Monopoly power arises whenever...

a firm faces a downward sloping demand curve Firms in all market structures except perfect competition face a downward sloping demand curve and therefore have varying degrees of monopoly power

Game theory

a mathematical technique analysing the behavior of decision-makers who are dependent on each other use strategic behaviour as they try to anticipate the behaviour of their rivals. -Can illustrate the characteristics of mutual interdependence, strategic behaviour, and conflicting incentives

firm (or business)

an organisation that employs factors of production to produce and sell a good or service.

Why is the demand curve in monopolistic competition in between monopoly and perfect comp

firm raises its price = lose more sales than the monopolist, (substitutes) lose fewer sales than the perfectly competitive firm (product differentiation) More elastic than Perf, less elastic than Monop

Strategy interdependence

firms are mutually interdependent - what happens to the profits of one firm depends on the strategies adopted by other firms

If firms are earning economic profit then...

revenue > (Implicit+explicit costs)

Profit maximisation: Economic (supernormal) profit or loss in the short run

short-run equilibrium position of the individual firm in monopolistic competition is identical to that of the monopolist. Only difference is demand curve is more elastic and flatter in monopolistic competition. In the short run, the firm can either make supernormal profit, normal profit or losses. The firm applies the MR = MC rule to find the profit maximising or loss-minimising level of output

Effects of price discrimination

the results of third-degree price discrimination are very complex and ambiguous, as they depend on a variety of factors, making it difficult to draw general conclusions. -Possibility of increased monopoly power. Firms can use price discrimination to charge high prices in one market and low prices in another market with the intention of driving out rival firms that may be unable to compete with the low price. -Total output may increase or decrease. If it increases, it does not reach the socially optimum level (allocative efficiency is not achieved). -If output increases, then under certain conditions allocative efficiency will also improve; if output falls, then allocative efficiency will worsen. -Different prices for different groups . Therefore, some consumer groups can benefit if a product that was previously not affordable now comes within their reach (for example, students, pensioners, leisure travellers who plan far ahead of time, mid-week restaurant goers, and many others). On the other hand, those groups who have to pay higher prices will clearly lose, and for some of them, the product will become unaffordable. -Consumer surplus increases for some groups and falls for others -What happens to overall consumer surplus depends on what happens to output. If output falls, consumer surplus falls; if output increases, consumer surplus may either increase or decrease, depending on the particular situation.

Price leadership - one type of informal collusion

where a dominant firm in the industry (may be the largest, or the one with lowest costs) sets a price and initiates any price changes. Remaining firms in the industry become price-takers, accepting the price that has been established by the leader. T he implicit agreement (as there is no formal agreement) binds the firms as far as price goes, but they are free to engage in non-price competition. - characteristic of price leadership arrangements - price changes tend to be infrequent, and are undertaken by the leader only when major demand or cost changes occur.

Obstacles to sustained price leadership are similar to the obstacles faced by cartels:

• Cost differences between firms, particularly where there is significant product differentiation, make it difficult for firms to follow a leader. • some firms may not follow the leader. The leader risks losing sales and market share if it initiates a price increase that is not followed. • Firms still face the incentive to cheat by lowering their price (below that of the leader) to capture market share and increase profits; a breakdown in price leadership can result in a price war among firms. • High industry profits can attract new firms that will cut into market shares and profits of established firms and endanger the price leadership arrangement. • Price leadership, depending on where and how it is practised, may or may not be legal.