CH 8 MARKET STRUCTURE AND OUTPUT-PRICING DECISIONS

Firms output and pricing decisions depend on the current market structure in which the firm is operating i.e. How much control over price we have.

whether the firm is competing in perfect competition, monopoly, monopolistic competition or oligopoly situation
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Competition vs. Monopoly

One useful way in which issues of competition and monopoly can be investigated is called the Structure,

Conduct and Performance Model

Competition vs. Monopoly continued

Market Structure
e.g. number of buyers and sellers (the size of firms)

Conduct
e.g. firm's goals, pricing and output, their investments

Performance
e.g. efficiency, profitability and growth

MC
AC

P*

D=MR=AR

Perfect Competition

Output

q*

Firms are price takers they face a perfectly elastic demand curve

market price changes only if demand or supply changes

Given the market price, what is the appropriate level of production?

Since market price will settle at the point where only normal profits are earned output will settle where

p = MC = AC = MR

Industry Demand Increase and the Long-Run Industry Supply Curve

P b
a c

S1

S2

Long-run S

D1

D2 Q

a) Constant industry costs

Industry Demand Increase and The LongRun Industry Supply Curve continued
P

S1

S2 Long-run S

b
a c D1

D2

Q b) Increasing industry costs: external diseconomies of scale

Industry Demand Increase and The LongRun Industry Supply Curve continued
P

S1

S2

b a

c
D1

Long-run S D2

Q
c) Decreasing industry costs: external economies 7 of scale

Why is perfect competition so rare in the real world - if it even exists at all?

One important reason for this has to do with economies of scale:

Perfect competition requires there to be many firms (non having a large market share). Firms must therefore be small under perfect competition - too small for economies of scale.

LAC2 LAC3
LAC1

D
8

Output

BUT

once a firm expands sufficiently to achieve economies of scale, it will usually gain market power it will be able to undercut the prices of smaller firms and so drive them out of business perfect competition will be destroyed therefore, perfect competition could only exist in an industry, if there were no (or virtually no) economies of scale
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Perfect Competition and Public Interest

Possible pluses:

the fact that p = mc leads to efficient resource allocation

competition between firms will spur to efficiency will encourage the development of new technology
there is no point in advertising!? in long-run equilibrium: LRAC at its minimum, so company producing at the least-cost output

consumers gain from low prices quick response to changed consumer tastes 10

Perfect Competition and Public Interest

continued

Pitfalls of perfect competition:

firms may be too small to afford R & D! produces only undifferentiated products

how about the taste of variety?!

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Monopoly

Why do monopolies exist? Barriers to entry

Control of scares resources or input

for

instance diamonds (De Beers) monopolies

Economies of scale
natural but

Technological superiority
not a guarantee if network externalities exist

Government-created barriers
Alko,

patents, copyrights
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MC ATC

P1
D = AR

Q1 MR

Demand function facing a monopoly is the market demand for the product Monopoly firms ability to set its market price is limited by the demand curve (demand elasticity)

downward sloping demand and MR-curves

But supernormal profits may be earned even in the long run

depends on how contestable the market is

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Monopoly and Public Interest

Disadvantages of monopoly:

higher prices and lower output than under perfect competition possibility of higher cost curves due to lack of competition
loss

of efficiency

unequal distribution of income

monopoly

profits
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Monopoly and Public Interest continued

Advantages of monopoly:

economies of scale possibility of lower cost curves due to more research and development and more investment competition for corporate control
innovation and new products
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F
P = AC1 MR

MC AC

D Output

Monopolistic Competition

Q1

Firms have some degree of market power

but demand curve typically flatter than in monopoly since there is more competition

Output-pricing decision is defined by MR = MC as always

the absence of entry barriers means that super normal profits are competed away...

firms end up producing where p = AC, but AC not at its minimum as in perfect competition, also p > MC

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Limitations of Monopolistic Competition Model

Information may be imperfect; firms will not enter an industry if they are unaware of the supernormal profits currently being made

Firms are likely to be different from each other not only in the product they produce or the service they offer, but also in their size and in their cost structure. Also the entry may not be completely unrestricted The model concentrates on price-output decisions; in practice the profit-maximizing firm under monopolistic competition will also need to decide the exact variety of products to produce and how much to spend on advertising
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Limitations of Monopolistic Competition Model continued

Compared to perfect competition:

less will be sold at a higher price firms will not be producing at the least-cost point (i.e. min AC) = firms have excess capacity

On the other hand it is often argued that these wastes are insignificant (since highly elastic demand curves and some scale economies gained) and perhaps well compensated to the consumer by the great variety of products to choose from

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Oligopoly

A market dominated by a few large firmsimperfect competition

How concentrated is an industry?

consider the market share of four largest firms

Some highly concentrated industries (in the world or in a country):

mobile phones, paper industry, cigarettes, batteries, automobiles, banking, breweries, airplane industry, oil industry, etc.
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Oligopoly continued
The essence of an oligopolistic industry is the need for each firm to consider how its own actions affect the decisions of its relatively few competitors
Oligopoly may be characterized by collusion or by non-co-operation

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Collusion and Cartels

COLLUSION an explicit or implicit agreement between existing firms to avoid or limit competition with one another
CARTEL is a situation in which formal agreements between firms are legally permitted

e.g. OPEC
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Collusion is difficult if:

There are many firms in the industry The product is not standardized
Demand and cost conditions are changing rapidly There are no barriers to entry

Firms have surplus capacity

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Tacit Collusion: Price Leadership

Dominant firm price leadership

Dominant firm sets the price for the industry, but lets followers sell all they want at that price. Dominant firm will provide rest of the market demand Followers, like in perfect competition, accept the price as given their joint supply is the sum of their MC curves (like in perfect competition)
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The leaders D-curve can be seen as that portion of market demand unfilled by the other firms, i.e. the difference between the market demand at each price and supply by followers at each price
MCleader
P1 a PL P2

Sall other firms

Dleader
b MRleader
QF QT

Leader sets MR = MC QL = QT - QF
Dmarket

Q
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Kinked demand for a firm under oligopoly

Demand curve kinked at current price:
The firm may expect rivals to respond if it reduces its price, as this will be seen as an aggressive move, so demand in response to a price reduction is likely to be relatively inelastic
P1
Tacit collusion outcome

but for a price increase

rivals are less likely to react, so demand may be relatively elastic above P1
D
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Q1

Stable price under conditions of a kinked demand curve

When Q < Q1, the MR curve corresponds to the shallow part of the AR curve

P1

MR

D = AR

Q1

Q 26

Stable price under conditions of a kinked demand curve continued

At Q > Q1, the MR curve will correspond to the steep part of the AR curve Note the cap between points a and b

P1

a b

D = AR

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Q1

MR

Stable price under conditions of a kinked demand curve

Price will tend to be stable, even in the face of an increase in marginal cost: if MC lies anywhere between a and b the profit-maximizing price and output will be P1 and Q1

P1

a
b
O Q1 MR

D = AR

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Stable price under conditions of a kinked demand curve continued

MC2 P1
MC1

b
O Q1

D = AR

MR

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Non-Collusive Oligopoly: Game Theory

A method of analyzing strategic behavior

behavior of a firm will depend on how it thinks its rivals will react to its policies

Invented by John von Neuman (1937)

and extended with Oskar Morgenstern (1944)

John Nash: Nash equilibrium (1949-1950)

a dominant strategy equilibrium

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Prisoners Dilemma an one-shot game

A two-person, non-zero-sum, noncooperative game with dominant strategy Dilemma: To confess or not to confess the crime committed

If confesses, can get a shorter prison time, but will the partner in crime confess or not? Best joint outcome if both would deny If only one talks he gets a minimum sentence and the other the maximum If both confess moderate outcome for both
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Prisoners Dilemma: Payoff Matrix

Johns strategies
Confess
Confess

Deny

3 years
3 years

10 years
1 year

Bobs strategies

1 year
Deny

2 years
2 years
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10 years

A Strategic Game Example

Soap Wars

Procter & Gamble and Unilever are engaged in a long running soap war, each company trying to capture a larger proportion of the detergent market

P&G has just started a huge marketing campaign to launch their new Ariel tablets and trying to convince the public that their product is better than the Persil tablets introduced by Unilever a year ago

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UK Detergent Market 1995-1998

60 50 40 30 20 10 0 Unilever P&G
1995 1998

Percil

Ariel
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The Two companies are constantly looking for strategies to raise market share and profits One way to do that is product development Tablets introduced Lets consider this as a strategic game Tit-for-tat repeated game

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Soap Wars: A Strategic Game

Unilevers strategies No tablet Launch tablet No tablet Procter&Gambles stragegies
+8% +8% -4% +12% -4% +4%

Launch +12% tablet

+4%
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Duopoly Payoff Matrix: The equilibrium

is a Nash equilibrium, both firms cheat
Company As strategies Cheat Comply Company Bs strategies Cheat
0 0 -1.0m

+4.5m +4.5m
+2m +2m

Comply

-1.0m

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Oligopoly and Public Interest

If oligopolists act collusively and jointly maximize industry profits, they will in effect be acting together like a monopoly and then the disadvantages to society would be the same as under monopoly Further more, in two respects, oligopoly may be more disadvantageous than monopoly:

Oligopolists are likely to engage in much more extensive advertising than a monopolist Depending on the size of individual oligopolists, there may be less scope for economies of scale to decrease the effects of market power
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Advantages of oligopoly to society over other market structures:

Can use part of the supernormal profits for R&D (incentive to do so

higher than in monopoly)

Non-price competition through product differentiation may result in greater choice for the consumers

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Non-Price Competition

Product Development
aims
leads

to develop products which will sell well and which are different from rivals' products
to less elastic and potentially high demand

Advertising
to

increase demand and to make demand curve less elastic

Advertising and product development not only increase a firm's demand and hence revenue, they also involve increased costs

so how much to spend in order to maximize profit? 40

The Changing Nature of Market Structure

the market types that actually exist in business situations are not always clear-cut or stable

the type of market in which a firm competes may change over the life of the products being sold Prof. Michael Porter has introduced a useful way to incorporate the possibility of change in market structure into the analysis of business decision making

the model of "five competitive forces"

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The Porter Competitive Framework

Potential Entrants

Threat of new entrants

Bargaining power of suppliers

Suppliers

Intra-Market buyers Rivalry Customers

Threat of substitute products or services
Substitute Markets

Bargaining power of

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