monopolistic competition and product differentiation krugman wells, chap. 16
TRANSCRIPT
Monopolistic Competition and Product Differentiation
Krugman Wells, Chap. 16
Monopolistic Competition
• Most firms produce a good that is (to a certain extent) unique. No other good has the exact same properties.– Coke, Pepsi, President’s Choice
• To the extent that you are a unique producer, you will have some market power.
• Price elasticity of individual products are larger than total category. But not infinite as in the case of commodity goods.
Monopolistic Competition:Short-term
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ATC
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Price
Output
Characteristics of Monopolistically Competitive Markets
• Differentiated Products• Free Entry into very similar markets.• Fixed costs of setting up production• Individual firms face downward sloping
demand curve and a falling average total cost curve.– They would sell more if they could at the
going rate but lowering their prices to sell more would lead to losses.
No Barriers to Entry
• What happens if new firms can enter?
• If there are profits to be had, entrepreneurs will enter markets to provide close substitutes for profit making goods.
• New goods splitting the market and better substitutes means lower, flatter demand curve.
Monopolistic Competition:Entry of Competitors
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Monopolistic Competition vs. Perfect Competition
• On a market-by-market basis, perfect competition will offer greater efficiency both in terms of minimizing deadweight losses and encouraging an efficient production scale.
• Monopolistic Competition only occurs with differentiated products. – Greater variety generated by this market may
compensate for loss of efficiency.
Monopolistic Competition:Long-term
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Output
Monopolistic Competition and Entrepreneurship
• New markets are frequently developed. • For many goods, the only barriers to entry
is imagination. • Entrepreneurs develop new ideas for new
goods. The pay-off for entrepreneurship are short-run monopoly profits. (Ted Turner and CNN). Only in rare cases will firms be able to make long-term monopolistic profits.
Consequences of Market Power
• One clear consequence of the existence of market power is that prices are higher than marginal cost and output is smaller than perfect competition.
• Additional consequences of the presence of market power may be:– Complacency by firms managers (i.e. standard
corporate governance measures do not generate efficiency)
– Rent-seeking: Firms may put effort into constructing artificial barriers to entry rather than producing goods.
Oligopoly
KW Chap. 15
Oligopoly
• Many industries are dominated by a small number of firms: Airlines, airplane manufacturing, supermarkets, drugstores.
• In theory, even a small number of firms may compete, driving down prices to the level of costs.– Airplane manufacturing: Boeing vs. Airbus
• Oligopolists may also collude!– OPEC– Sotheby’s and Christie’s
Concentration Ratios are often used to measure market competition
Concentration RatiosScheduled passenger air transportation Trucking Industry
Share orTop 4 Firms 33.7 7.6Top 8 Firms 50.8 12.6Top 20 Firms 73.1 21.2Top 50 Firms 89.9 28.9
Four Firm Concentration Ratio: Sales of Top 4 Firms Divided by Total Sales
Conditions of Cartel
• Small number of firms• Barriers to Entry• Ineffective or Non-existent government
regulation.
• Way to Stop Cheating–Enforcer–Capacity Constraints (California
Electricity Market)
Duopolists• Two companies can agree on a price at which they could
make profits. • If the other firm keeps its word, you can win whole
market by undercutting their price.• If the other firm doesn’t keep its word, you must undercut
the agreed upon price or lose everything.• Either way, best strategy is to cheat on agreement.
Q P Revenue MR Cost ATC MC Profit Split Cheat50 550 27500 18750 375 8750 4375 11250
475 37575 525 39375 28125 375 11250 5625 12500
425 375100 500 50000 37500 375 12500 6250 12500
375 375125 475 59375 46875 375 12500 6250 11250
325 375150 450 67500 56250 375 11250 5625 8750
Payoff Matrix
• Two firms • Each one could choose to
collude and charge a price of 475.
• Or each could decide to cheat, steal the market for themselves and charge a price of 450
• The matrix describes the payoff of each firm given the strategies of another.
Red Firm 1
Blue
Firm
2
Collude Cheat
Collude 6250,
6250
0,
11,250
Cheat 11,250,
0
5625
5625
Game Theory & Beautiful Mind
• Game Theory is a branch of math that describes strategic interactions.
• Nash describes a game that is in equilibrium as one in which no player has an incentive to change their strategy given the strategy of the other player.
• Nash equilibrium in the above game is for both to cheat even though they both players would be better off if they could collude.
California, 2000
• In 1998, utilities in California’s deregulated wholesale power market were paying between $30 and $40 per MWH. By summer and fall of 2000, prices skyrocketed to $140.
• Five firms producing wholesale electricity (Enron, Dynegy,…). When there is excess capacity, five firm market behaved relatively competitively.
• When capacity constraints hit, firms could exercise significant pricing power and raise prices above marginal cost.
Sotheby’s and ChristiesPrior to 1995, Sotheby's and Christie's, the world's largest auction houses, were in fierce competition for consignments from sellers. ,… . In March 1995, this competition abruptly ended. Christie's … would charge sellers a fixed, non-negotiable commission … and a month later Sotheby's announced the same policies. Detailed documents kept by …, Christie's former chief executive, show that the abrupt change was due to a price-fixing conspiracy.
Anatomy of the Rise and Fall of a Price-Fixing Conspiracy: Auctions at Sotheby's and Christie's Orley Ashenfelter and Kathryn Graddy
Why were these firms able to successfully form a cartel?
Firms may compare future profits from staying in cartel relative to current profits from cheating. In lean markets, the benefits from cheating may be less than the future benefits from staying in a cartel.
Boeing vs. Airbus.
• Why might it be difficult for two airlines to collude.
• There is a large stock of existing aircraft available for sale in used market.
• Durable goods producers have to compete with their own past.
• Some economists claim that Alcoa did not have a monopoly because the broad supply of recycled Aluminum.
Price Discrimination
• What if you don’t have to charge the same price to everyone?
• If you have perfect knowledge of the valuation applied to your product by each customer, you might tailor your price for each one.
• Since lowering your price for each customer doesn’t affect the price obtained from higher value customers, you gain by selling at a price above marginal cost.
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MC = 3
Total profit earned by firmP1
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Perfect Price Discrimination will generate same output as perfect competion, but monopolist will take all surplus as profit.
Learning Outcomes
Students should be able to: • Characterize the relationship between price, marginal
revenue, marginal cost, average total cost, and profits in a monopolistically competitive market in the short and long run.
• Describe the conditions that characterize markets with oligopoly.
• Define price discrimination and discuss the costs and benefits to the firm and society.
• Evaluate the difficulties of maintaining collusion.• Measure oligopolistic conditions with concentration
ratios.
Contestable Marketsand Strategies to Deter Entry
• A monopoly firm may not set profit maximizing prices because they want to keep the price low enough to keep other firms out.
• A market in which the possibility of market entry tempers the behaviors of monopolists is called a contestable market. – A pricing strategy to prevent entry is called limit
pricing.
• Firms may also use other strategies to deter entry which are less beneficial than lowering prices and increasing production.
Strategies of Entry Deterrence
• A firm may deter entry by competitors by threatening them with :– Engaging in predatory pricing.
• Price below marginal cost to drive another firm out of the market.
– Building excess capacity (promise predatory pricing)
Surplus• The demand curve represents how much consumers
are willing to pay for one more unit of a good, if they have already bought a certain number of goods.
• There are diminishing returns to any given product. As people consume more of that product, the benefit they get from consuming another one declines, and they are only willing to pay a lower price.
• Difference between the price people are willing to pay for a good (i.e. the position of the price schedule) and the actual price is the consumer surplus (net benefit to the consumer) generated by that purchase.
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P = 3
Surplus generated by buying first good = 6
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P = 3
Surplus generated by buying second good = 5
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P = 3
Total consumer surplus is the sum of surplus of each good
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When goods adjust continuously, total consumer surplus is a triangle created by price line and demand curve
Producer Surplus
• Producers achieve profits whenever they sell an extra goods at a price above the cost of producing the extra good.
• Sum of profits for each good is the total producer surplus, the area in the triangle below the price line and above the supply curve.
Supply and Demand
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Competitive Market
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SProducer Surplus
Competitive Equilibrium is Efficient
• Economic efficiency means that there are no gains to be had at the level of society from additional trades.
• If the price is higher or lower, the sum of the areas of the consumer & producer surplus triangles will be less than at the equilibrium price.
• Economic efficiency does not guarantee that the split of the surplus will coincide with any notion of fairness.
Efficient Equilibrium Market
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Producer Surplus
Consumer Surplus
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Monopoly Price
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Ceiling
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Total Societal Surplus is lower under monopoly
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Ceiling
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Consumer Surplus
Deadweight Loss S
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