Reading 13: Firm and Market Structures
Market Structures
Perfect competition
Characteristics
No barriers to entry into or exit from the industry.
Products are homogeneous, perfect substitute from each other; no advertising or branding.
No pricing power (supply and demand determine market price) price taker
Monopolistic competition
Characteristics
Low barrier to entry into or exit from the industry
Product are good substitutes but differentiated
Firm has some pricing power.
Oligopoly
Characteristics
High barrier to entry into or exit from the industry
Product can be similar or differentiated
Firms may have significant pricing power.
Monopoly
Characteristics
Very high barriers to entry into or exit from the industry
No good substitutes
Significant pricing power
Many sellers, each of which is small relative to the market.
Many firms.
Few interdepending sellers
a single seller
Elasticity, and Relationship between P, MR, MC
(In Equilibrium) Price = Marginal Revenue (MR) = Marginal Cost (MC)
Perfectly elastic demand curve (horizontal)
Economic profit = 0
Elasticity, and Relationship between P, MR, MC
In short-run: P > MR = MC
Elasticity (Ed) > 1 (elastic but not perfectly, down-ward sloping)
Elasticity, and Relationship between P, MR, MC
Price > MR = MC (in Equilibrium)
Elasticity \((E_{d})\)> 1
Economic profit > 0 in long run but moves toward 0 over time
Elasticity, and Relationship between P, MR, MC
Price > MR = MC (in equilibrium)
Elasticity \((E_{d})\)> 1
Economic profit > 0 in long run
Profit maybe = 0 due to expenditure to preserve monopoly
Firm's supply function
Short-run supply curve
Long-run supply curve
Does not have well-defined supply functions
Some Oligopoly models
Does not have well-defined supply functions
Optimal Price & Output
To maximize profit, produce at : P = MR = MC (also at that same point)
Optimal Price & Output
Optimal Output: MR = MC
Face downward-sloping demand curves, so price is determined from the price on demand curve for the optimal ouput
Optimal Price & Output
Optimal Output: MR = MC
Face downward-sloping demand curves, so price is determined from the price on demand curve for the optimal ouput
Optimal Price & Output
Optimal Output: MR = MC
Face downward-sloping demand curves, so price is determined from the price on demand curve for the optimal ouput
Pricing strategy
Not clear pricing strategy since firms are interdependent
Optimal pricing and output strategy depends on assumption made about other firms' cost structure and competitors' response to the firm's price change
Factors affecting long-run equilibrium
An Increase (decrease) in demand will increase (decrease) short-run economic profit
Unless barriers are high, positive economic --> more firms enter the market --> increase market supply --> decrease market price and quantity traded in equilibrium
Unless barriers are high, negative economic profit --> more firms exit the market --> decrease market supply --> increase market price and quantity traded in equilibrium
Concentration Measures in identifying market structure
Concentration Ratio for N firms: % of market sales from N largest firms
Herfindahl - Hirschman Index: sum of squared market shares of the largest N firms (DO NOT WRITE IN PERCENTAGE 30% -> 0.3). --> better reflect the effect of mergers on industry concentration
Cons: neither measures market power directly, so both can be misleading when potential competition restricts pricing power.
How to Identify the market structure?
Examine Number of firms in the indsutry
Whether products are differentiated?
Do non-price competitions exist?
Do barriers to entry/exit exist?
Compete via price only
Compete via Price, Marketing, Features, etc.
Compete via Price, Marketing, Features, etc.
Compete via Advertising
the portion of the firm's short-run marginal cost (MC) curve above the average cost (AC)
Initially, Economic profit = Q x (P - ATC)
In the long run, ATC = P or Economic Profit = 0
the portion of the firm's long-run marginal cost (MC) curve above the average total cost (ATC)
Firm strategy
If P < AVC: stop immediately
If AVC < P < ATC: work in short-run, stop in long-run
P = ATC: Long-run equilibrium
P > ATC: Not sustainable in long-run
Increase in demand
Short-run
Long-run
Price goes up, inside firms enjoy economic profits, outsiders wanna join the industry
Outsider joins the industry, increasing supply.
Price goes down (maybe to the original price)
Quantity produced increases
Horizontal Demand Curve, also is the MR curve
Downward-sloping demand curve, even steeper MR curve
(Economic profit) Average profit = P - ATC
In long-run: P=ATC (price falls as new firms enter)
Economic profit = 0
Potential allocative efficiency is not clear
Social cost of not producing where P = MC
Long-run average cost is not minimized
wasting resources on advertising
Fewer producer could be more efficient
However, product diversity, thus innovations create customer's benefit
Benefits of Monopolistic Competition
Brand name provide signals about quality
Product innovation and differentiation have value
Value of advertising
Provide valuable information to consumers
High advertising expenditure may increase AFC and thus ATC
However, if advertising greatly increases sales, ATC can decline as AFC falls
Downward-sloping demand curve, even steeper MR curve
Kinked-demand model
Đường Demand Curve gấp khúc
Competitors will not follow a price increase, but WILL follow a price DECREASE
A discontinuous (gap) MR curve
Does not show how to specify market price P
Cournot Model
Duopoly model
Assumptions
Same product
Firms have market power
Firms choose quantities simutaneously
Both firms have identical and constant MC
Conclusions
Both produce the same quantity in Nash equilibrium
Market price lower than monopoly, but higher than perfect competition
As more firms are added, market price moves toward marginal cost (closer to perfect competition)
Collusion
If Ogilopoly Colludes
Each firm will have equal economic profits
If not colludes
No firm has economic profit, causing perfect competition.
Prisoner's Dilemma
If competitors cannot detect cheating, they will choose to violate the collusion agreement and increase output
Nash equilibrium: Choices of all firms are such that no other choice make any firms better off (increases profits or decreases losses)
NOT THE BEST OUTCOME FOR EITHER FIRM
Dominant Firm Model
One dominant firm is the low-cost producer
Dominant firm produces most of the output
Dominant firm essentially set market price P
Other firms take that price as given
Price discrimination
charging different consumers different prices for the same product or service
Assumptions
Seller has a downward-sloping demand curve
Seller has at least two identifiable groups of customers with different price elasticities of demand for the product
Seller can prevent the customers paying the lower price from reselling the product
If seller can do price discrimination to every single consumer, there will be no Dead Weight Loss, but all consumer surplus will be captured by seller
Pricing strategy under each market structure
Perfect competition
Produce Quantity for which MR = MC =P
Monopoly
Produce at quantity where MR = MC, but at that point P > MR = MC
Monopolistic competition
Produce at quantity where MR = MC, but at that point P > MR = MC
Oligopoly
Kinked demand curve
Produce at quantity where MR = MC
Discontinuous MR curve, so that for the same Kinked demand curve there can be different cost structures.
Collusion
Produce at quantity for which MR = MC
Agree to ALL charge the price corresponding with that quantity in the Industry Demand Curve
Dominant firm model
Firms must agree to share the total output among themselves and not steal market share from each other
Dominant firm will produce at quantity where MR = MC of the firm, and charge price corresponding with that quantity at the firm's demand curve
Other firms produce at quantity where MC = dominant firm's price
Game Theory
Nash equilibrium
Natural Monopoly
large economies of scale
If other firm joints, ATC will increase
Regulation
Average cost pricing
Force monopolist to produce at the price and quantity corresponding with the monopolist's ATC cuts market's demand curve
Effects
Increase output and decrease price.
Increase social welfare (allocative efficiency).
Ensure the monopolist a normal profit because P = ATC.
Marginal cost pricing
Force monopolist to produce where firm's MC curve intersects the market demand curve
Give subsidy, as monopolist has to produce where MR =MC < ATC
Sell the monopoly right to the highest bidder
the winning bidder will be an efficient supplier that bids an amount equal to the value of expected economic profit and sets prices equal to long-run average cost.
\(MR=P-\frac{1}{E_{p}}\)
If one firm decreases price, some other firms will have to quit as they cannot compete, the market share of dominant firms will increase.
Identify Nash equilibrium: take turn and see options in each player's eyes (temporarily hide the others' choice) then choose the most selfish option for each player.
In long-run, dominant firm's market share will decrease as profit attracts new firms to enter the market
Degree
First degree:
Monopolist charges the highest price possible that consumer will pay
Second degree
Monopolist gives a price menu where consumer will choose the most appropriate
Third degree
Consumers are segregated by demographics and other traits, then are charged accordingly