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CH 8 MARKET STRUCTURE AND OUTPUT-PRICING DECISIONS  Firms output and pricing decisions depend on

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

Competition vs. Monopoly

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

Conduct and Performance Model

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Competition vs. Monopoly continued Market Conduct Performance Structure e.g. number of e.g. firm's goals, e.g.

Competition vs. Monopoly continued

Market Conduct Performance Structure e.g. number of e.g. firm's goals, e.g. efficiency, buyers and sellers
Market
Conduct
Performance
Structure
e.g. number of
e.g. firm's goals,
e.g. efficiency,
buyers and sellers
pricing and output,
profitability and
(the size of firms)
their investments
growth
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Perfect Competition MC AC P* D=MR=AR Output q*  Firms are price takers  they

Perfect Competition

MC
MC

AC

P*

D=MR=AR

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

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Industry Demand Increase and the Long-Run Industry Supply Curve P S 1 S 2 b

Industry Demand Increase and the Long-Run Industry Supply Curve

P

S 1 S 2 b a c D 2 D 1
S 1
S 2
b
a
c
D 2
D 1

Long-run S

Q

a) Constant industry costs

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Industry Demand Increase and The Long- Run Industry Supply Curve continued P S 1 S

Industry Demand Increase and The Long- Run Industry Supply Curve continued

P

S 1 S 2 b c a D 2 D 1
S 1
S 2
b
c
a
D 2
D 1

Q

Long-run S

b) Increasing industry costs: external

diseconomies of scale

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Industry Demand Increase and The Long- Run Industry Supply Curve continued P c) S 1

Industry Demand Increase and The Long- Run Industry Supply Curve continued

P

c)

S 1 S 2 b a c D 1 D 2
S 1
S 2
b
a
c
D 1
D 2

Long-run S

Q

Decreasing industry costs: external economies

of scale

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

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.

LAC 2 LAC 3 LAC 1 D 8
LAC 2
LAC 3
LAC 1
D
8

Output

BUT  once a firm expands sufficiently to achieve economies of scale, it will usually

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

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

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Perfect Competition and Public Interest continued Pitfalls of perfect competition:  firms may be too

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

Monopoly

Why do monopolies exist?

Barriers to entry

Control of scares resources or input

for instance diamonds (De Beers)

Economies of scale

natural monopolies

Technological superiority

but not a guarantee if network externalities exist

Government-created barriers

Alko, patents, copyrights

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P 1 MC ATC D = AR MR Q 1  Demand function facing a

P 1

MC ATC D = AR MR Q 1
MC
ATC
D = AR
MR
Q 1

Demand function facing a monopoly is the market demand for the product

Monopoly firm’s 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

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

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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MC AC F MR D Q 1 P = AC 1 Monopolistic Competition Output 
MC AC F MR D
MC AC
F
MR
D

Q 1

P = AC 1

Monopolistic Competition

Output

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

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

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 firms — imperfect competition How concentrated

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

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

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

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

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 leader’s 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

P 1

P L

P 2

price

MC leader S all other firms a D leader Leader sets MR = MC Q
MC
leader
S all other firms
a
D
leader
Leader sets MR = MC
Q L = Q T - Q F
b
D
market
MR leader
Q
Q F
Q T
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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

P 1

O

Tacit collusion outcome
Tacit collusion
outcome

but for a price increase

rivals are less likely to react,

so demand may be relatively elastic above P 1

Q 1

D

Q

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Stable price under conditions of a kinked demand curve When Q < Q 1 ,

Stable price under conditions of a

kinked demand curve

When Q < Q 1, the MR curve corresponds to the shallow part of the AR curve

P 1

MR

O

Q 1

a

D = AR

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Q

Stable price under conditions of a kinked demand curve continued

At Q > Q 1 , the MR curve will correspond to the steep part of the AR curve

Note the cap between points a and b

P 1

O

will correspond to the steep part of the AR curve Note the cap between points a

a

b

Q 1

MR

D = AR

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Q

Stable price under conditions of a kinked demand curve

Price will tend to be stable, even in the face

P 1

O

of an increase in marginal cost:

a

b

Q 1

if MC lies anywhere between a and b the profit-maximizing price and output will be P 1 and Q 1

MR

D = AR

Q

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Stable price under conditions of a kinked demand curve continued

P 1

O

Stable price under conditions of a kinked demand curve continued P 1 O Q a b
Stable price under conditions of a kinked demand curve continued P 1 O Q a b
Stable price under conditions of a kinked demand curve continued P 1 O Q a b

Q

a

b

1

MR

MC 2

MC 1

D = AR

Q

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Non-Collusive Oligopoly: Game Theory  A method of analyzing strategic behavior  behavior of a

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, non- cooperative game with dominant

Prisoners’ Dilemma – an one-shot game

A two-person, non-zero-sum, non- cooperative 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 John’s strategies Confess Deny 3 years 10 years Confess 3 years

Prisoners’ Dilemma: Payoff Matrix

John’s strategies

Confess Deny 3 years 10 years Confess 3 years 1 year 2 years 1 year
Confess
Deny
3 years
10 years
Confess
3 years
1 year
2 years
1 year
10 years
2 years
Deny
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Bob’s strategies
A Strategic Game Example Soap Wars  Procter & Gamble and Unilever are engaged in

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 1995 1998 Unilever P&G

UK Detergent Market 1995-1998

60

50

40

30

20

10

0

199560 50 40 30 20 10 0 1998

199860 50 40 30 20 10 0 1995

Unilever P&G Percil Ariel
Unilever
P&G
Percil
Ariel
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 The Two companies are constantly looking for strategies to raise market share and profits

The Two companies are constantly looking for strategies to raise market share and profits

One way to do that is product development

Tablets introduced

Let’s consider this as a strategic game

Tit-for-tat repeated game

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Soap Wars: A Strategic Game Unilever’s strategies No tablet Launch tablet No tablet +8% +12%

Soap Wars: A Strategic Game

Unilever’s strategies

No tablet

Launch tablet

No tablet +8% +12% +8% -4% -4% +4% Launch +12% +4% tablet 36 Procter&Gamble’s stragegies
No tablet
+8%
+12%
+8%
-4%
-4%
+4%
Launch
+12%
+4%
tablet
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Procter&Gamble’s
stragegies

Company B’s strategies

Company B’s strategies Duopoly Payoff Matrix: The equilibrium is a Nash equilibrium, both firms cheat Cheat

Duopoly Payoff Matrix: The equilibrium

is a Nash equilibrium, both firms cheat

Cheat

Comply

Company A’s strategies

Cheat Comply £0 -£1.0m £0 +£4.5m +£4.5m +£2m -£1.0m +£2m 37
Cheat
Comply
£0
-£1.0m
£0
+£4.5m
+£4.5m
+£2m
-£1.0m
+£2m
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Oligopoly and Public Interest  If oligopolists act collusively and jointly maximize industry profits, they

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

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 to develop products which will sell well and

Non-Price Competition

Product Development

aims to develop products which will sell well and which are different from rivals' products

leads 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?

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The Changing Nature of Market Structure  the market types that actually exist in business

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 Intra-Market Rivalry Substitute Markets

The Porter Competitive Framework

Potential

Entrants

Threat of new entrants

Intra-Market

Rivalry

Substitute

Markets

Bargaining power

of suppliers

Bargaining power of

buyers

Suppliers

Customers

Bargaining power of suppliers Bargaining power of buyers Suppliers Customers Threat of substitute products or services
Bargaining power of suppliers Bargaining power of buyers Suppliers Customers Threat of substitute products or services

Threat of substitute

products or services

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