Chapter 10 Other Markets Microeconomics PDF

Chapter 10 Other Market Structures ©1 Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM Please note that in this chapter we use interchangeably, the terms: firm, producer, supplier, owners of a f...

Chapter 10 Other Market Structures ©1 Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM Please note that in this chapter we use interchangeably, the terms: firm, producer, supplier, owners of a firm, and managers of a firm. Perfect Competition involves an ideal type of interaction among market participants. Free entry and exit controls the greed of each participant and leads him or her to promote the public interest by promoting own interest. Monopoly is another extreme market structure in which there is no free entry and no free exit, the demanders know very little about the product they might purchase, no perfect information, inefficient allocation of resources, deadweight loss, and inequitable income distribution. Because of lack of free entry in many of the real world markets, unbridled greed leads to an inefficient allocation of resources, chronic unemployment, and poverty for some a substantial number of participants in real world markets, know as workers. Between the two extremes, there are other market structures. These allow different levels of interactions among participants and create other hurdles to free entry and exit. The type of interaction among participants and degree of greed control we observe in a given market depends on the market's structure. The following table offers a classification of the important market structures we find in the real world. Table 1 Market Structures Number of Type of Entry Nature of Elasticity of perceived Market Structure Firms and Exit Products or actual Demand curve for one producer Perfect Large Free Homogenous Perfectly Elastic Competition Monopolistic Large Free Differentiated Elastic Competition Oligopoly Small Restricted Differentiated Elastic Cartel Small or large No Homogenous Elastic, Inelastic Monopoly One No Homogenous Elastic, Inelastic As Table 1 shows, markets of monopolistic competition have free entry and exit in the long run but not in the short run. They usually have a large number of producer or supplier firms. Each producer or supplier has a differentiated product with own demand curve that allows her/him to act like a monopolist in the short run. The demand curve is fairly elastic in the short run. It becomes very elastic in the long run and very close to the perceived demand curve for a producer operating under perfect competitive in long run equilibrium. Monopolistic competition is the closest market structure to perfect competition. Oligopoly is a market structure with a small number of producers or suppliers. Sometimes, they sell a homogenous product but most likely, they sell differentiated products. Car manufactures are an example of an oligopoly. The bigger the percentage of sales accounted for by the four largest firms in 1Cartago Research and Development, 8/20/24, 4:25 PM Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -2 an industry the more the industry resembles a monopoly. The smaller the percentage of sales accounted for by the four largest firms the more the industry resembles monopolistic competition. When firms in an industry sell a homogenous product but they agree among each other to behave like a monopoly, we call the industry a cartel. Usually, the number of firms in a cartel is small so that it is easy for them to communicate with each other and agree on a common price that would maximize the total economic profit of the industry. If their number is small, the cartel member can police each other easily and can more easily agree on how to share industry’s total economic profit and location of markets. For example in the beer industry, airline industry, and the food industry, the managers of different firms may agree to share markets. They agree for example to divide the country into as many regions as there are firms in the cartel. Each firm in the cartel or oligopoly serves one and only one region of the country or of the world. Within that region, its managers or owners are free to set the price and maximize their total economic profit. The agreement is that the managers of no other firm in the industry would trespass on the other’s territory. To protect their market against new comers, the managers of a firm assigned to a region would enter into an agreement with the local governments not to license other producers or suppliers of the product to operate in their region. In exchange, they would agree to produce all output sold within the region and give other special favours to the local government’s officials or local organizations. A good example is the beer industry. In the previous chapters, we studied perfect competition and monopoly. In this chapter, we use the same tools and add to them new ones to study monopolistic competition, oligopolies, and cartels. We start with monopolistic competition. Monopolistic Competition In monopolistic competition, there are a relatively large number of firms and entry and exit are relatively easy in the long term but not in the short term. Each firm produces a differentiated product. Product differentiation help a firm’s managers to maintain a certain degree of monopoly in the short run and thus enable then to charge a price different from those charged by their competitors for the same type of product. Product differentiation reinforced by advertising helps to create for each firm a core of loyal customers who judge quality by price for lack of information because it is expensive to acquire and/or process correctly relevant information about the product. The managers of each firm that is operating under monopolistic competition hope to earn a positive total economic profit or increase it by creating an environment that allows them to create a demand curve exclusively for their product and make decisions about the price of their product. From the point of view of the managers of a firm operating in monopolistic competition, the problem for firms operating in a market under perfect competition is that in the long run their managers earn in the long run only a normal profit. In the long run equilibrium under perfect competition, a firm loses all its customers when its managers raise their product price above the market equilibrium price. Thus, the creation of own core of loyal customers is a very appealing strategy to the managers of a firm operating under monopolistic competition. The managers of such a firm think that this core allows their firm to escape the fate of a firm operating in a market under perfect competition. The managers of a firm that adopts this strategy hope to face a downward sloping demand curve of their own. When they raise the price of their product, they will lose some not all of their customers but they will also produce less, save on costs, increase total revenue and increase their total economic profit. Even if they lose a little bit of total revenue, the total cost savings if they are greater than the loss in total revenue, would result in an increase in total economic profit.. That is, the managers of a firm operating in a monopolistic competition market would behave like a miniature monopolist in the hope that in the long run they can take over the whole industry and Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -3 become a full-blown monopolist in their product market. Fortunately, free entry and exit in the long run and advertising by every firm in that product market forces the managers of any firm in monopolistic competition to face an outcome similar to that achieved by the managers of a firm operating under perfect competition. Like with perfect competition, there is a difference between the short and long run outcomes. We start with the short run analysis. Short Run Equilibrium Like a monopolist, the managers of a firm operating under monopolistic competition choose the quantity to produce and sell and the corresponding price to maximize their firm’s total economic profit. They created a differentiated product and a corresponding short run downward sloping demand curve like demand curve FG in figure 1. Curve FK in figure 1 is the corresponding marginal revenue MR curve associated with demand curve FG. Figure 1 Short Run Equilibrium in Monopolistic Competition Price or Unit Cost Short Run Marginal Cost Curve N F J Short Run Demand Curve L Short Run Average Total R Cost Curve A M PM H ACM B C E PE Marginal Revenue K Curve Short Run Marginal Cost Curve G 0 QM QE Quantity MRE The firm has an average total cost ATC curve and a marginal cost MC curve as represented in figure 1 respectively by curves JCER and NKER. Since the firm’s managers can raise the price in the short run without losing too many customers, they would raise the price and lower the quantity produced as long as MR is less than MC. For example, starting at E in figure 1 where they are charging a price equal to the minimum average cost, the quantity demanded and produced is equal to QE, the total economic profit is zero. At EH MR < 0 < MC = PE. > 0. They would raise the price and reduce the quantity produced and quantity demanded by one following their demand curve FE. Their total cost falls by the MC, which is bigger than zero and their total revenue increases by the negative of their MR at QM. Their total economic profit would rise. Similarly, if they start a quantity lower than QM with MR > MC, the firm’s managers would lower the price and raise the quantity produced and quantity demanded by one unit along their demand curve FE. The additional revenue is equal to MR more than covers the additional cost MC and total economic profits would rise Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -4 Thus, the managers of a firm operating under monopolistic competition would maximize total economic profit when they produce and sell a quantity of output that equates MR to MC. In figure 1, QM maximizes total economic profit because at that quantity of output, MR = MC. The firm’s managers would set the price of their product equal to PM as given by the firm’s short run demand curve FG at point M in figure 1. Area ABCM in figure 1 is equal to the maximum total economic profit. Since price PM is greater than the marginal revenue MR at QM, it follows that the marginal social benefit, which is equal to PM, is greater than the marginal social cost, which is equal to the short run marginal cost at QM. Thus, at the short run equilibrium of a firm operating in a market under monopolistic competition, The marginal social benefit is greater than the marginal social cost There is a deadweight loss given by the surface of area EKM in figure 1. In addition, the firm will not be producing at the minimum short run average cost or there is excess capacity and waste of resources. We now turn to the question of how a firm’s managers can create a demand curve for their product that is not perfectly elastic. Advertising and Product Differentiation Without product differentiation, no firm can ever hope to maintain a downward sloping demand curve that enables it to charge a higher price without losing all its customers. Product differentiation can be real in the sense that if it helps the economy achieve a better allocation of resources and raise the standard of living of some people without reducing that of any other member of society. In reality, product differentiation comes at a cost; it can be misused to accomplish the opposite. By spending money on research and development, managers of firms may help develop new products that are more useful or procure a higher level of satisfaction to consumers. This is the case for example of pharmaceutical companies or cellular phone equipment producing companies. Some of the new attributes of the product they develop can be obvious; other are more specialized and may not be obvious. Without appropriate education about the attributes of new products, consumers may not be able to appreciate the better quality of the new products. From the social point of view, it is efficient that consumers have full information about all the attributes of the products that they are buying. The managers of privately controlled firms would promote the public interest when they use advertising for the purpose of explaining the attributes of their products and their usefulness. In order to perform this useful function, the firm’s managers need to cover the costs of providing the information. Their total cost must include an allowance for the cost of development of the better attributes of the product and the costs of advertising as required if the market of their product is to achieve an efficient allocation of resources. Consequently, under perfect competition the long run equilibrium price must be higher and there must be a tight correlation between long run equilibrium price and the overall quality of a product. The trouble starts when the firm’s managers use advertising to build a core of loyal customers who take the shortcut of judging quality by price, by the looks of a product, and/or by false claims about the scientific characteristics of the product. Using advertising for such purpose helps managers create a downward sloping demand curve for their product and to lower its elasticity. Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -5 If the firm’s managers were producing and selling the same product that every other firm sells, like wheat for farmers, they would perceive that they have a demand curve similar to demand curve ABC in figure 2. Suppose that market equilibrium price is $1. If the managers of a firm were operating under perfect competition and they charge a price higher than $1, no one would buy from them. At any price greater than the market equilibrium price, the quantity demanded for their firm’s product is zero. Segment AB describes the set of prices for which the quantity demanded is zero. At the market equilibrium price, the firm’s managers can sell any output they can produce at an average total cost less than the equilibrium price. They will not sell at a lower price than the equilibrium price. Horizontal segment BC in figure 2.a describes their perceived demand curve Along segment BC in figure 2.a, the elasticity of this demand curve is infinite and the demand curve is perfectly elastic because any attempt by the firm’s managers to increase would cause them to lose all their customers. The percentage change in quantity demanded would be infinitely large compared to the percentage rise in price. Figure 2 Perceived demand Curve for a Firm Figure 2.a Perfect Competition Figure 2.a Monopolistic Competition: Own Advertising Advertising: 8 Price Lower Price Price Elasticity 7 Advertising: A Higher F 6 Willingness to Pay 5 D E 4 B 3 C 1 C 2 A 1 B 0 0 Quantity 0 10 20 30 40 50 60 70 Quantity In contrast, with product differentiation and intensive advertising, the managers of a firm in monopolistic competition can carve a demand curve for their product, shift it upward as from AB to CD in figure 2.b and reduce its price elasticity as from CD to CF. Given that uninformed or poorly informed consumers judge quality by price, this would allow the managers to charge a higher price without losing a significant proportion of their loyal customers. Advertising combined with entertainment is a powerful tool. A firm’s managers use it to gain more customers at the expense of other firms in the industry and to change the elasticity of their own product’s demand curve. While some kind of advertisement may help increase the total economic profits of existing firms, it is also useful from the social or public interest point of view. As we shall see presently, it allows new entrants to reduce the efficiency loss resulting from the monopolistic behaviour of firms engaged in monopolistic competition. Thus, advertising is useful when the goal from using it is to educate the public about the actual attributes of a truly new product or to enable free entry of potential producers whose aim is to enter Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -6 with a number of units of capital input equal to the minimum efficiency size or with a product of similar quality or better quality than that offered by existing producers and operate with a number of units of capital input equal to the minimum efficiency size. By promoting their private interest, firms in monopolistic competition promote the public interest. In contrast, some producers or sellers use advertising to create imaginary differences that serve to foster product loyalty, reduce the elasticity of the demand curve for their product and displace it upwards at the expense of other competitors. This kind of advertisement is misleading; raises average total cost. It wastes resources and can perpetuate efficiency losses. It does not promote the public interest even though it promotes the private interest of firm managers or owners who engage in it. Long Run Equilibrium Like under perfect competition, there is free entry and exit in monopolistic competition. Potential producers of the product are attracted into the industry when they realize that each one of the existing firms in the industry are making a significant total economic profit, such as area ABCM in figure 1 indicates. In this kind of industry, advertising costs and the sunk costs are not large. Thus, exit is easy. Entry is easy also because there is no large start up specialized equipment to purchase and thus there are no large economies of scale. Most importantly, prospective producers of the product attracted by total economic profits enjoyed by existing firms can easily launch their new products and take away some of the customers from each one of the existing firms. We shall show that this causes the managers of each of the existing firms to lower their product price and bring it down to a level close to the minimum long run average cost. Through the use of advertising, new entrepreneurs cause the demand curve of an existing firm to become more elastic and to shift downwards or to the left. The appearance of close substitute products increases the responsiveness of consumers to an increase in the price of an existing firm and reduces the willingness to pay for its product. Figure 3 Transformation of the Demand Curve of a Firm in a Market of Monopolistic Competition Following Entry of More Competitors in the Market In figure 3, the demand curve AB of an existing firm rotates counter-clockwise to a position such that of demand curve AC, showing an increased responsiveness to the same price change. For example if the managers of the existing firm raise the price of their product from $6 to $7, their demand curve AB Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -7 shows that the quantity demanded decreases by QA – QD =10 units. However, in response to the same increase of its price from $6 to $7, the decrease in the quantity demanded along demand curve AC is equal to QA – QC = 50 units, much larger than the amount QA – QD =10 units of decrease of the quantity demanded along demand curve AB. Thus, the price elasticity of demand curve AB is much smaller than the price elasticity of demand curve AC. In addition, the decrease in the willingness to pay for an additional unit of the product of the existing firm causes its demand curve to shift downwards from AC to HK. Like demand curve AC, demand curve HK is much more elastic than demand curve AB. As long as existing firms are making economic profits, more firms will come into the industry. The demand curves of existing firms will continue to shift downwards, become more elastic and closer to a horizontal line. This reduces the total economic profits of any existing firm. With enough entry, the demand curve of an existing firm would slide below the long run average cost curve wiping out its economic profit and transforming it into loss. There is no more incentive for new firms to enter the industry. If existing firms make a loss, the new comers could not do any better since in the long run every body has access to the same technology. Some of the firms would exit and the demand curves of existing firms would edge upwards until they all become tangent to the common long run average cost curve. Thus, the industry achieves a long run equilibrium when enough firms enter the industry to push the demand curve for each firm (existing and new) to have only one point in common with, i.e. to become tangent to, the common long run average cost curve and become much more elastic. Figures 4.a and 4.b illustrate the transition from a short run equilibrium to the final long run equilibrium of a product market operating under monopolistic competition. Starting from a short run equilibrium position with a short run demand curve FG in figure 4.a, the managers of a firm operating in monopolistic competition maximize its total economic profit at QM = 40 units and charges a price PM= $11. Area ABCM in figure 4.a represents the firm’s maximum short run total economic profit. We note the inefficiency of this short run equilibrium that the firm’s managers attempt to maintain through additional spending on advertising. The firm’s managers are producing an output that is lower than the output of 50 units that minimize the short run average total cost and the output of 70 units that minimizes the long run average cost. Figure 4.a Short Run Equilibrium of a Firm in Monopolistic Competition. Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -8 Figure 4.b Long Run Equilibrium of a Firm in Monopolistic Competition. The positive total economic profit attracts more entrepreneurs into the industry. Since there are no barriers to entry new entrepreneurs will enter with an efficiency size firm and they will use advertising to create own demand curve for their product, forcing the managers of the incumbent existing firms to follow suit, eventually opting for an efficiency size and the managers of each one of the existing firms will eventually face a demand curve that has shifted downward and it has a much greater price elasticity as we learned earlier with the help of figure 3. Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -9 As figure 4.b shows, the demand curve for the product of an existing firm shifts downward from FG to NH and its price elasticity increases substantially. Also the average total cost curve is replaced by the long run average cost curve as competition forces the existing firms to change the number of units of capital input and the technology used for production and use an efficiency size capital stock. Finally, the entry of new producers will stop only when the maximum total economic profit for each producer in the industry, incumbent or new entrant, is driven down to zero. This will take place only if the demand curve for each producer becomes tangent to the long run average cost, curve as shown in figure 4.b by the tangency of demand curve RH and the long run average cost curve DHER at point H where the output is equal to QML = 60 units. Furthermore, the long run marginal revenue curve NK associated with the long run demand curve NH must intersect the long run marginal cost curve JKES at a level of output QML = 60 units at which the long run demand curve NH is tangent to the long run average cost curve DHER so that no producer has the incentive to choose a different output and price to achieve a positive total economic profit. Every one of them can earn a total normal profit no more. The maximum price any producer can charge is equal to $4, equal to the long run average total cost at QML = 60 units as shown in Figure 4.b. They all charge the same price. The price seems to be an indication of quality. It is the useful advertising that will inform the demanders of the quality of the product, which is then a truly homogeneous product, since there are no patents and there is free entry and exit. As figure 4.b indicates, the minimum long run average total cost of $4 occurs at point E, at an output equal to 70 units on the long run average cost curve. The minimum long run average total cost of $4 is also equal to the long marginal cost, equal to the marginal social cost, and equal to the marginal social benefit. We note that QML is close to output QE that minimizes the long run average cost P ML is close to the minimum long run average cost. Thus, in the long run, firms in monopolistic competition behave almost like firms in perfect competition. They really cannot set their price as they wish even though they think they can. They also produce at output that is close to that produced by each firm if the market was operating under perfect competition. The resulting resource allocation is close to an efficient allocation. The invisible hand with perfect information and free entry and exit has done its job. It has provided the necessary mechanism to control, to a large extent, greed and it makes greed work for the benefit of promoting the public interest. In the real world, the fly in the ointment is the cooperation between greed, political influence, logrolling in elections in democratic societies, and the managers of the financial system. Natural Oligopoly In monopolistic competition, there is free entry and exit in the long run. Thus, economies of scale are not large. In a natural monopoly, economies of scale are so large that only one firm can supply the whole market at a price equal to the minimum average cost. Essentially this enables the managers of the first established firm, supported by the lender-managers of the financial system to vary the price of their product to ward off competitors in the long run and share in the higher total economic profit. The possibility for the managers of the first established firm to lower the price when a competitor shows up acts as a virtual formidable barrier to entry. In the real world, there are many industries between the two extreme forms of market organization, monopolistic competition and natural monopoly. The managers of firms in the industries located between the two extremes can use relatively large economies of scale combined with other artificial Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -10 arrangements helped by the managers of financial institutions effectively to ward off competitors and earn a positive total economic profit in the long run that both groups of managers would share. Figure 5 Natural oligopoly Figure 5.a Figure 5.b Figure5.c Price, unit Cost Firm 1 Firm 2 Price, unit Cost Market Long Run Long Run Long Run Long Run Average Marginal Marginal Market Demand Curve, Average Cost Cost Cost Cost Marginal Social Benefit C C Curve C J C J G B D 1.25 1.25 A A 1 A H Marginal Social Cost 0 1.5 Q1= 3 Q2= 3 6 Output Output Quantity Consider the case of a product where economies of scale are large but not as large as in the case of a natural monopoly. The U shaped curve CAC in figure 5.a and figure 5.b represents the long run average cost of producing this product. The minimum long run average cost is equal to $1, achieved at an output equal to 3 units. Since the long run marginal cost curve meets the long run average cost curve at the minimum of the latter, the long run marginal cost at 3 units in figures 5.a and 5.b is equal to the minimum long run average cost equal to $1. Thus, the marginal social cost at six units is equal to $1 and the marginal social cost curve HAG in figure 5.c crosses the market demand curve DA, which is also the marginal social benefit curve, at point A. At A the quantity demanded at a price equal to the minimum long run average cost of $1 is equal to 6 units and the marginal social benefit is equal to the marginal social cost. Accordingly, the quantity demanded and the required quantity supplied that maximize the total net social benefit are both equal to 6 units, To produce this quantity at the lowest social cost, we need only two firms, each one of them producing an equal amount of 3 units at a minimum long run average cost of $1. If we use more than two firms to produce 6 units, the average cost in at least one of the firms would be greater than the minimum long run average cost of $1. Indeed, for none of them the average cost will be less than $1 and average cost for at least of them will be higher than $1. For example, suppose that we use four firms to produce the 6 units such that each one of them would produce 1.5 units. Figure 5.a shows that the average cost given by the height of the long run average cost curve CAC at point B is $1.25. This is greater than the average cost of $1 attained by using only two firms each one of them producing 3 units. In general, if due to economies of scale, the minimum efficiency size is large relative to the quantity demanded of a product at a price equal to the minimum long run average cost, then only a small number of firms is needed to achieve an efficient allocation of resources. In this situation we have a natural oligopoly. Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -11 Definition of a natural oligopoly: A natural oligopoly is an industry where economies of scale are large enough that the minimum efficiency size is large relative to the quantity demanded of a product at a price equal to the minimum long run average cost so that only a small number of firms is needed to achieve an efficient allocation of resources. As we shall see presently, a natural oligopoly industry is friendly to neither perfect competition nor monopolistic competition. When left to fall under the control of private interests, it will degenerate into a monopoly thanks to assistance from the financial system. A Cartel or a Collusive Oligopoly To simplify, consider a natural oligopoly with two firms only needed to produce the quantity demanded of a product at a price equal to the minimum long run average cost of the efficiency size. Furthermore, suppose that the two firms are privately controlled. Figures 6.a and 6.b illustrate respectively the average total cost and marginal cost corresponding to the identical minimum efficiency size of firm 1 and firm 2. In figure 6.c, curve DA is the demand curve for the product, curve DF is the corresponding marginal revenue curve and Curve FAC represents the marginal cost of the two firms combined when each operating at the minimum efficiency size. Curve FAC in figure 6.c is also the marginal social cost. According to Figure 6.c, the long run minimum average cost is equal to $1. The efficient amount of the total output of this product is 6 units where the marginal social benefit is equal to the marginal social cost at point A and the quantity demanded is equal to the total quantity produced by the two firms, equal to 6 units. If the managers of each firm produce 3 units, half of the quantity demanded of the product at a price of $1 equal to the minimum long run average cost associated with the minimum efficiency size of the capital stock and charge that price, they would make a zero total economic profit but they earn a normal profit, which is included in the total economic cost. In this situation, the market for this product achieves an efficient allocation of resources. Soon, however, the managers of the two firms, that form the natural oligopoly, discover that if they can agree to behave like a monopolist with two factories, they can increase the total economic profits of each firm by raising their prices and lowering their outputs. This strategy requires that the managers of the two firms agree on a common price, the total quantity to produce and supply to the market and how much their respective firms would produce and supply. Figure 6 A Cartel Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -12 Starting at A in figure 6.c, when the managers of the two firms agree to lower the sum of their outputs by one unit from 6 units to 5 units, they can raise the price along demand curve DA. They save the marginal cost equal to $1 but lose the marginal revenue MR = $0 as given by curve DF in figure 6.c. Since marginal cost = $1 > marginal revenue MR = $0 at A, it follows that the cost savings at A is greater than the loss in revenue and the total economic profit of the two firms combined must rise by $1 = $1 - $0. In general, if the managers of the two firms collude and behave like a monopolist does, they would choose that level of total output that equates marginal revenue MR to the marginal cost MC of the two firms combined, each of which is operating with the efficiency size of the number of units of capital input. The combined MC is also the marginal social cost. According to figure 6.c, the output that maximizes the total economic profit of the two firms combined when controlled by a monopolist is equal to 4 units where the marginal revenue is equal to the marginal cost at the intersection point F of the marginal revenue curve and the marginal cost curve. Point G on the demand curve DA gives the maximum common price the managers of each firm can charge. This price is equal to $1.3. Each one of the two firms would produce 2 units, equal to half of the total output. According to the average cost curve CAC in figure 6.a, at an output level of 2 units, the average cost is $1.1. Therefore, the total economic profit for each firm is (Price - Long run average cost) x quantity = ($1.3 - $1.1) * 2 = $0.4. The red shaded areas in figures 6.a and 6.c represent the share of each firm in the maximum total economic profit. If the product is homogenous, it is necessary that the managers of each firm respect the agreement and produce only 2 units. In total, they produce 4 units, an amount equal to the quantity demanded at a price of $1.3. To make it easy to verify the agreement, they may agree to share the market along geographical lines and the managers of each firm agree not to market their production in the other firm's territory. We call this kind of arrangement a CARTEL. For the cartel to survive, the managers of each firm must pay certain favours, pecuniary or at the voting urn, to their government politicians in exchange for commitment of the respective local government politicians to make it illegal to import into their respective province, territory, or from other countries, similar products. This is for example the case of the beer industry. The favours may be Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -13 pecuniary contributions to the corresponding political parties and/or an agreement by the members of the cartel to produce all her/his output in the province or state of the local government, and make donations to local organizations. The power of the local governments is crucial for the success of a cartel. If there is no effective policing method, it is not easy to prevent members of the cartel from raiding each other’s territory. For example, if the managers of firm 1 produce an additional unit, their average cost would decrease for example to $1 and they could sell it in firm 2’s territory at a price less than $1.3. Some of the customers of firm 2 would desert it and buy under the table from a representative of firm 1. This would destroy the agreement and the cartel would collapse. In short, governments play a major role in helping cartels survive. Another less clear but equally serious threat is the threat from latent or potential competitors. Other entrepreneurs would realize in due time that the members of the cartel are making economic profit. This would attract these potential competitors into the industry provided they can find a financial institution whose managers are willing to finance the creation of a new firm. To ward them off, the managers of the members of the cartel would automatically lower their price to $1 and increase output. Since this is a natural oligopoly of two firms only, the potential competitor would soon realize that if she enters, everyone would make a loss, especially her, as she would have to spend extra money to build up its clientele. Because the initial investment is generally substantial and some of it is a substantial sunk cost, the potential competitor would lose most of her/his initial investment if it decides to leave. Thus, there is no free exit and the potential competitor would not actually enter. Once they dissuade the intruder not to enter, the existing members of the cartel would raise the price again. Since the success of the cartel requires cooperation to raise and lower the price simultaneously, we call the cartel an example of a collusive oligopoly. As is clear from figure 6, like monopoly, cartels cause a deadweight loss. Triangle AGF represents the deadweight loss caused by a cartel. The formation of a carter causes a permanent loss of employment in their sector, corresponding to the output loss, which is equal to difference between the most efficient level of the output of the product and the total amount that the members of the cartel actually produce to maximize the total economic profit of the cartel. The formation of the carter also causes emigration of financial capital and know-how to other countries in search of employment and profit opportunities. The financial capital that leaves the country would help produce goods and services outside the country. Later, the members of the cartel import those products back into the country, if there are no barriers to or tariffs on imports if the country is a member of the World Trade Organization. Cartels are also good targets for labour unions that seek to raise the wages of their members to or above the perfect competition equilibrium wage. Since the managers of every member of the cartel are making economic profits, they can afford to pay higher wages. In the long run, both the higher cartel prices and higher union wages would reinforce each other and reduce the competitiveness of the domestic industry with respect to imports from other countries. Finally, like monopoly, a cartel causes an inequitable distribution of income. In industries where monopolistic competition prevails, the managers or owners of firms cannot earn economic profit in the long run, and their workers earn a normal equilibrium wage. In contrast, members of a cartel do earn an economic profit and their workers may earn wages above a level that is consistent with an efficient allocation of resources. Oligopoly Cartels are a special case of Oligopoly or what economists call Restricted Competition. This is the case of an industry where the economies of scale are substantial but not very large and it is expensive for demanders to have and/or process information about the quality of the industry’s Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -14 products. Starting from a monopolistic competition, the managers or owners of a few of the existing firms acquire some or all of their competitors with the help of the financial sector and sometimes with the help of government officials and economic policy. As a result, a few relatively large firms emerge and their managers, owners, or those people who acquired control of those large firms are able to erect formidable barriers to entry or exit through advertising, price manipulation, or pressure on managers of financial institutions to limit entry in the industry by refusing to lend to prospective entrants. Of course, a cartel is an oligopoly par excellence. Oligopoly firms face two basic major problems: How to reduce price competition among existing members and how to prevent new entry. One way to ward off new competitors is to have large economies of scale such as in a natural oligopoly. When the product is homogenous, members of a natural oligopoly must find a way to enforce agreements on market sharing. A successful way is to strike deals with local governments to restrict access to the regional market by other members of the oligopoly. While relatively large economies of scale are helpful to fend off new competitors, they are not enough to insure that any member of the oligopoly does not trespass on the territory of another member. In the remainder of this chapter, we discuss ways that the managers of member firms of an oligopoly use to solve these problems Supply Management by mini-Cartels Enlisting a properly designed government intervention to control entry into a market is sufficient to insure a cartel’s survival even if the existing number of members is quite large and there are small economies of scale. The two crucial goals of the cartel are to regulate the entry into the industry and enforce an easily verifiable rule for market sharing. Cartel members can achieve these two goals through licensing with the help of local or nation wide governments. Licensing allows existing producers to transform an otherwise competitive industry into a cartel. If the number of producers is large enough that it can make a difference in the voting booths of a democratic society, the producers can strike a deal with a political party that unless access to their industry is licensed they will vote for the other party. For example, dairy producers have succeeded in setting a ceiling on the number of licenses to produce a certain quantity of milk. They have convinced the government to set first a complete prohibition on the importation of liquid milk. After a recent international trade agreement that created the world trade organization, the government of Canada agreed to replace the prohibition by a tariff of 300% or more on imported milk and cheese. Licensing limits the number of members of the cartel and the amount each one can produce. The existing producers can even lobby for reducing the output allowed for each license. They can meet together and decide the price to charge just as a cartel does on the basis of the given information about the demand curve of the product. Thus, they become a monopoly. The government sanction helps to police the behaviour of each other. Without the help of governments, they would never succeed in keeping the members of the cartel together. Politicians seeking re-election can hardly ignore the demand of the aggressive members of their constituencies (members of the cartel) to initiate and actively support the required licensing legislation. Thus, we can easily understand the creation and proliferation of so many mini cartels aimed at eliminating competition. You find them in professions like doctors, nurses, accountants, lawyers, judges, real estate, stock market brokers, stock market traders, and certain other lines of economic activity. They are also popular among producers in certain industries such as wheat farmers, insurance companies, on the ground transportation companies, sea shipping companies, airlines, cable companies, telecommunications companies, construction and so on. They all need government sanction to succeed and they are all essentially monopolies. To justify their monopoly and the government sanction and support, they invoke the need for society to protect the public safety or security. Public safety and security is nothing but a facade. They all create dead weight losses and increased Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -15 unemployment and poverty. Because they raise prices above the competitive level, they can make economic profit and reduce the real purchasing power of wages. Thus, workers who can organize themselves easily into unions would strive for raising wages above the competitive level causing further increases in unemployment. Together mini-cartels, cartels, monopolies and unions cause an emigration of capital to other countries where such restrictions on trade do not exist. The country’s evicted capital would come back to compete with the mini cartels by exporting back to its mother country the products of other countries. During the early 1990’s after the break-up of the then Union of Soviet Socialist Republics in the early 1990’s, the increase of the unemployment rate in Germany and the low unemployment rate in the neighbouring Check republic is an example of this kind of outcome. Despite the relatively high unemployment rate in Germany, German firms moved some of their operations and capital out of Germany into the neighbouring Check Republic to take advantage of wages that were then as much as two thirds lower than in Germany. Mergers and Market Share Another way to coordinate price and output across firms in the same industry is to create a large company out of an amalgamation of small companies through mergers or acquisitions with the help of the managers of financial institutions in the form of credit facilities. This can be done in many ways. Horizontal mergers Firms in an industry agree to merge into one large firm creating essentially a cartel. The existing firms become divisions of a large firm. The individual firms can and do in many cases keep their management unchanged. Under a unified management, the management teams of the various divisions can coordinate their price policy easily. More importantly, they would agree to share the market along geographical lines or along types of clientele (rich or middle class, domestic or foreign market). The agreement would obviate the need to find ways or spend money to police each other or pay government officials to enforce market sharing. Since the original firms keep their names and product labels, the large firm can also give the impression to the public that the various firms are competing with each other like they were under monopolistic competition. This is the case of the newspaper, radio, cable industries, and car manufacturing industries…. As the population grows and markets expand with rising incomes, demand expands and economies of scale remain relatively unchanged. To pre-empt the creation of new firms that would make pricing and market sharing more difficult to police, the existing firms in a natural oligopoly will expand by creating new divisions. This would prevent the industry from evolving into an industry closer to monopolistic competition. Even though this would raise the costs of management, it saves the costs of policing agreements and frequent conflicts. This is the case of the car manufacturing industry and metal refining industries such as steel, aluminium, and copper industries. In these industries, market share becomes important not because a larger share lowers unit production costs, actually it may increase them, but because it lowers the costs of enforcing a common price and market sharing agreements. Vertical mergers In this kind of merger, two or more firms at different stages of the production process merge and become one firm. For example, a firm producing computers merges with a firm producing microprocessor chips. A firm that assembles cars merges with a firm that produces car bodies or engines. In the nineteen twenties, General Motors merged with Fisher bodies. This makes it difficult for a new firm to enter into the industry of a consumer good without at the same time producing its own intermediate products or raw material. The required initial capital becomes larger, and the risk of losing own capital is greater. Thus, the barriers to entry and exit become more formidable. Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -16 Consequently, the number of firms in consumer products is restrained and the policy of fixing the same price and sharing markets among existing firms becomes that much easier and less costly. Note there are little gains in terms of economies of scale. Some people defend vertical mergers on the premise that they permit gains in quality and efficiency. In addition, mergers make it possible for firms with good management to export that management to the other poorly managed firms with which they merge. Of course, such claims are hard to verify. However, they certainly help existing firms to control better the markets, especially expanding markets. Oligopoly with Product Differentiation If the members of a natural oligopoly cannot get the government to help them police each other or restrict entry, they have another method of maintaining a quasi monopoly price. Since they are members of a natural oligopoly, they can use their large economies of scale together with a tacit understanding about prices to ward off new competition. The problem remains how to police each other in terms of market sharing. One way to achieve this is to introduce product differentiation. They can create imaginary product differentiation by advertising. Such activity may help in the short run but consumers are rational enough that in the long run they create consumer associations or purchase information such as from consumer reports to make sure that they are not duped. Therefore, members of a natural oligopoly must reinforce frequently their imaginary product differentiation by true product differentiation. They can differentiate their products by advertising to make it easier to share markets and help police their price and quantity agreements. Though their products are essentially the same, they bear different labels. The use of advertising and product labelling enables the members of a natural oligopoly to create a core of loyal customers and a demand curve for each one of their products. They can reinforce product differentiation by offering different after sale services. They can also reinforce product differentiation by undertaking research to improve the quality and the looks of their products. In this way, the market becomes segmented and there is no need to agree on quantities. The members of the natural oligopoly need only agree tacitly or explicitly on the price. To maintain market shares members of the oligopoly must keep up with each other’s new products and technological improvements. A good example of this is the car industry, audiovisual industry, and the appliance industry. These advertising expenditures become a barrier to entry and a barrier to exit. Since product differentiation and advertising solve the problem of market sharing, there is only one major problem left for members of an oligopoly. How can they agree on setting the prices for their respective products? In the United States and somewhat in Canada, antimonopoly laws forbid firms in the same industry from entering into explicit agreements about prices. Thus, member firms of a natural or collusive oligopoly need to find a tacit agreement to set prices. The following section describes a well-known method of achieving price agreements without violating anti-monopoly laws. Government Industrial Policy In some other countries like Japan, the government encourages firms in natural oligopoly to set prices and to compete in quality. The government of Japan helps Japanese firms by providing them with research facilities to develop new products and make the results available to all Japanese firms. The famous Ministry of International Trade and Industry (MITI) helps firms in every industry make price decisions that are not legally binding but understood to apply to all firms in the industry, existing or new. By making it legal to discuss and set prices, the government of Japan allowed MITI to participate in the pricing decisions of Japanese firms. Thus, it is hoped that MITI would guide the members of an oligopoly to set prices near the minimum long run average cost. The Japanese government main argument for shepherding all Japanese industries is that this approach allows firms to avoid destructive price competition, wasting scarce resources, and perhaps dead weight losses by preventing price manipulations that keep potential competitors away. If the Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -17 price is set near the minimum long run average cost, there is no need for restricting employment. With the growth of demand, the door is open for new firms to enter into the market since the maximum number of firms needed to produce an ever-increasing quantity demanded at the minimum average cost increases. That avoids also the waste of resources as new firms test the market. It helps firms to concentrate on quality competition and thus on research and development. In setting the price, MITI may also keep in mind research and development costs. This may produce prices that are greater than the minimum long run average cost of capital and labour based only on current technology. It could, actually help solve the problem of ensuring recovery of research and development costs without the side effects of an excessively long patent period. Thus, in many cases Japanese prices at current exchange rates are substantially higher than prices for equivalent products in North America. However, in most cases the quality of the products sold in Japan is significantly higher. One possible explanation is the pricing strategy that was just outlined. Another explanation is that the distribution sector in Japan is far too complicated that it imposes high profit margins at each of many contrived stages resulting in high prices. We note that despite repeated denials to the contrary by many politicians and officials of the governments of many advanced and non advanced countries, the officials and politicians of the Japanese government are not the only government officials in the world who are engaged in some sort of industrial policy, Most government politicians, representatives in parliaments, interest groups, and lobbyists are of most countries in the world are engaged in supporting oligopolies, mini cartels and certain industrial polices. Price Leadership and Competitive Fringe To enforce a particular configuration of market sharing, it is not necessary to acquire all firms in an industry. It may be just enough to merge, acquire or expand to create a firm just big enough to control the market. The managers of the dominant firm that would emerge would be able to control the other much smaller firms, members of the industry, by the threat to lower the price. Economists call the smaller firms the competitive fringe. Let curve AB in figure 7.b be the demand curve for the whole industry. The competitive fringe or the managers or owners of the smaller firms are price takers as in perfect competition. Suppose that the competitive fringe is composed of ten identical firms but otherwise they behave like oligopoly members, towing the line. For each price that the managers of the dominant firm fix, the managers of each one of the competitive fringe firms would equate that price to their marginal cost and produce the quantity that would maximize their own total economic profit. The supply curve of each firm is the section of their marginal cost curve above their minimum average (variable) cost. In figure 7.a, this is section AJ of the marginal cost curve SAJ above the minimum average cost curve CAN that is associated with the minimum efficiency size of a competitive fringe firm. For example if the managers of the dominant firm fix a price equal to $1.3, then point B in figure 7.a shows that the managers of each firm of the competitive fringe would produce and supply a quantity equal to 4 units where their marginal cost is equal to $1.3 for a total of 40 units = 4 x10 units produced and supplied by the whole competitive fringe. Point B in Figure 7.b shows that the market quantity demanded is 80 units at a price equal to $1.3. Thus, the dominant firm would be left with a quantity demanded of 40 units (= 80 units - 40 units). The demand curve of the dominant firm passes through point G = (40 units, $1.3) in figure 7.b Figure 7 Oligopoly with a Price Leader Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -18 (a) A (b) Price Competitive Fringe Price Dominant Firm S C MC MC= LRAC Supply Dom inant Firm D LRAC Dem and Total Market 1.3 G B 1.3 G B Demand 1.1 H A 1 H A S F MR 3 4 20 30 40 60 80 90 Output Quantity Demanded 60 Output If the managers of the dominant firm lower their price to $1, point A of figure 7.a shows that the managers of each one of the competitive fringe firms would produce and supply a quantity equal to 3 units where their marginal cost is equal to $1 according to their marginal cost SAS for a total of 30 units = 3 x10 units produced and supplied by the whole competitive fringe. Point A in Figure 7.b on the market demand curve AB shows that the market quantity demanded increases to 90 units. Thus, at a price of $1, the managers of the dominant firm are left with a quantity demanded equal to 60 units = 90 units - 30 units. Point H = (60 units, $1) in figure 7.b is on the demand curve DGH of the dominant firm. Connecting such points as G and H, we build up the demand curve for the dominant curve as shown by curve DGH in figure 7.b. The demand curve DGH for the dominant firm has a marginal revenue curve DF. Based on this residual demand curve DGH and the marginal cost curve FHK corresponding to a stock of capital of the dominant firm close to its minimum efficiency size. The managers of the dominant firm would choose their output and quantity supplied to maximize their own total economic profit. As in the case of monopoly, the managers of the dominant firm would choose to produce that output which equates the marginal revenue of their dominant firm to its marginal cost. Figure 7.b shows that the managers of the dominant firm would maximize their firm’s total economic profit at point F, where their firm’s marginal cost is equal to their firm’s marginal revenue and their optimal output 40 units where their dominant firm’s marginal cost curve FHK intersects their dominant firm’s marginal revenue curve DF. The managers of the dominant firm will set a price for the product equal to $1.3 given by their dominant firm’s demand curve DGH at the corresponding output of 40 units. Each firm in the competitive fringe would produce 4 units as given by its supply curve or marginal cost curve in figure 7.a for a total of 40 units. Both the dominant firm and the firms in the competitive fringe would make a profit given respectively by the shaded green rectangles in figures 7.b and 7.a. Economists call the dominant firm the price leader. The managers of the price leader firm maintain the firms in the competitive fringe alive to protect their firm from government prosecution for violation of the 1889 Canadian Anti-Combines Law and its new version the 1986 Competition Law. The managers of the firms in the competitive fringe have all the incentive not to undercut the price leader since they earn a positive total economic profit. The price leadership arrangement is quite stable. Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -19 Note that the total output of the industry is 80 units. The output that would maximize the total net social benefit is 90 units given by the market demand curve BA at a price equal to the minimum long run average cost of $1. An industry with a dominant firm and a price leader has the following characteristics: It produces an inefficient level of output, restrains employment and does not operate at minimum long run average cost. It solves the oligopoly problem of free entry and exit with the help of the managers of financial institutions by: o The carrot of paying them a rent in excess of the interest on their loans and o The stick of the threat that the managers of the price leader firm will not pay interest nor pay back their loans if new competitors, financed by loans from the financial institutions and attracted by the economic profit of the competitive fringe, would succeed in entering the industry. It solves the oligopoly problem of price competition Conclusion Between the two extreme market structures of perfect competition and monopoly, there is a spectrum of market structures. Some of them look like perfect competition and some of them look like monopoly. Monopolistic competition is a market structure that exhibits characteristics similar to monopoly in the short run. Each firm has its own demand curve, which it creates by advertising and product differentiation. Some product differentiation is imaginary and some is real and helps the economy to achieve an allocation close to an efficient allocation. Advertising helps in creating both kinds of product differentiation. It also increases the amount customers are willing to pay for a unit of the firm’s product and helps make a firm's demand curve less elastic allowing the managers to generate more economic profit. In the short run, the managers of a firm operating under monopolistic competition set the output at that level which equates their firm’s marginal revenue to its marginal cost. The price they will charge is given by the firm’s demand curve. In the short run, firms in monopolistic competition, like monopoly, restrict employment and cause a dead weight loss. In the long run, there is free entry and exit in markets operating under monopolistic competition. Together with advertising, free entry and exit controls the greed of managers of and those who control firms operating under monopolistic competition. Attracted by the economic profits made by the managers of existing firms and with the help of own advertising, prospective producers create new firms and enter the industry. The advertising by the new entrepreneurs causes the demand curves for existing firms to shift downwards or to the left and become more elastic by reducing the impact of false advertising and offering similar and very close substitute products. Entry of new firms continues, causing the prices of the existing firms to fall until all economic profits of every firm in the industry are eliminated. Consequently, the amount produced by each existing firm is larger, the average cost is lower, and new firms produce more output. The total output produced by the industry increases and becomes closer to that level which maximizes total net social benefit. The average cost decreases and becomes close to the minimum long run average cost, excess capacity decreases, and all firms will operate with stock of physical capital close to a minimum efficiency size. Employment of physical capital and labour expands. Thus, in the long run, thanks to free entry and exit, useful advertising, and equal access to financial resources, this market structure can reduce significantly the deadweight loss it creates and converge Chapter 10: Other Market Structures, Chapter 10 Other Markets Microeconomics, July 2023, 8/20/2024 4:25 PM 10 -20 to an equilibrium that is close to equilibrium under perfect competition that results in an efficient allocation of resources. Natural oligopoly is a market structure close to monopoly. The existence of relatively large economies of scale makes entry and exit into the industry difficult thanks to the help of financial institutions to the first prospective producers. An industry is a natural oligopoly if, due to relatively large economies of scale, only a small number of firms is required to satisfy the market’s quantity demanded at a price equal to the minimum long run average cost. Sooner, the managers of and/or those control each one of the existing oligopoly firms realize that if they can agree to raise the price and reduce their total output they could generate a positive economic profit. However, raising the price requires restricting output. It is relatively easy to agree to raise the price but hard to monitor compliance and agree on how to restrict output. The existing producers need to work out arrangements to share the market, monitor each other output and prices, and enforce agreements, which are not binding in a court of law. A Cartel is a natural oligopoly with a homogenous product whose members agree to behave like a monopoly to raise the price of the product and restrict output. The members of some cartels may agree on market sharing based on a geographic criterion such as region of a country or regions of the world. Three other ways to share markets are product differentiation, mergers leading to a situation with one dominant firm over a competitive fringe. Supply management in many developed countries, such as in agriculture or other products industries such as for military purposes, provides examples of market sharing with the help of their respective governments. They are mini cartels created by associations of a large number of producers operating small efficiency size firms who would otherwise be operating in markets very close to perfect competition markets with zero total economic profit in the long run. Oligopolies, like monopolies, restrict output create dead weight losses and unemployment. They create social problems and inequitable distributions of income. This imposes additional financial burdens on government budgets. The resulting inequities create incentives for otherwise competitive industries to lobby the government with special favours for the right to manage supply by the creation of mini-cartels. Politically, it is not difficult to resist such demands, creating more unemployment problems and more government budget deficits. It is no wonder that when producers and sellers associations proliferate in a country that allows free trade, the country’s economy loses a lot of its jobs and efficiency in production to other countries that have no such restrictions on perfect competition.