Chapter 11: Market Structure, Monopoly, and Imperfect Competition PDF

Chapter 11: Market structure Monopoly and imperfect competition Faculty of Management and Commerce  Learning outcomes Once you have studied this chapter you should be able to explain the equilibrium position of a monopolist analyse the equilibrium posit...

Chapter 11: Market structure Monopoly and imperfect competition Faculty of Management and Commerce  Learning outcomes Once you have studied this chapter you should be able to explain the equilibrium position of a monopolist analyse the equilibrium position of a monopolistically competitive firm discuss the key features of oligopoly compare the outcome under perfect competition with the outcome under other market structures discuss the advantages and disadvantages of bigness explain the purpose of competition policy © VAN SCHAIK PUBLISHERS  Monopoly Monopoly is a market structure in which there is only one seller of a good or service that has no close substitutes. A monopoly is a firm that is the sole seller of a product without close substitutes. The key difference between monopoly and perfect competition: A monopoly firm has market power, the ability to influence the market price of the product it sells. A competitive firm has no market power. It’s a price taker. 3 © VAN SCHAIK PUBLISHERS  Monopoly  There is only one producer or seller of goods and only one provider of services in the market.  New firms find extreme difficulty in entering the market. The existing monopolist is considered giant in its field or industry.  There are no available substitute goods or services so that it is considered unique.  It controls the total supply of raw materials in the industry and has no control over price.  It owns a patent or copyright.  Its operations are under economies of scale. 4 © VAN SCHAIK PUBLISHERS  Monopoly The main cause of monopolies is barriers to entry – other firms cannot enter the market. Three sources of barriers to entry: 1. A single firm owns a key resource. E.g., Transnet owns South African ports and railway infrastructure 2. The govt gives a single firm the exclusive right to produce the good. E.g., patents, copyright laws 3. Natural monopoly: a single firm can produce the entire market Q at lower cost than could several firms 5 © VAN SCHAIK PUBLISHERS  Natural Monopoly Natural monopoly cases occurs when one firm can supply the entire market at a lower price than two or more firms can. When there is room for only one firm in an industry to produce a product efficiently. This occurs when the average cost of production is still declining at levels of output that are greater than those likely to be demanded. The reason for the falling average cost is usually that production requires a large initial capital outlay. Barriers to entry © VAN SCHAIK PUBLISHERS  Monopoly Natural monopoly occurs when the economies of scale are so large that there is room for only one firm in the industry. Limited size of the market relevant in South Africa, since the economy is relatively small and isolated geographically from international markets. Many South (and southern) African markets can support only one or a few large firms, especially in industries that require large capital expenditure. The exclusive ownership of raw materials. Patents - patent is the legal right granted to the inventor of a product, technique or process that allows him or her a temporary exclusive use of the product, technique or process atented (usually for 20 years). © VAN SCHAIK PUBLISHERS  Monopoly Licensing - licences may be used to control entry into certain industries, occupations or professions. Governments may grant licences to one or a limited number of firms to supply a particular good or service. Import restrictions- even if there is only one producer of a particular good or service in a country, that producer is often subject to competition from foreign firms. To protect themselves from import competition, the domestic monopolies lobby (ie try to persuade) government to impose import restrictions (eg in the form of import quotas or tariffs). Established firms can also create their own barriers to entry by applying strategies aimed at discouraging new firms from entering the market or forcing them out once they have entered. This can take many forms, including predatory pricing and maintaining excess capacity. Predatory pricing refers to the situation where existing firms lower their prices to below the new entrant’s costs of production, in order to drive out the new entrant and discourage future entry. © VAN SCHAIK PUBLISHERS  Monopoly Box 11-1 Barriers to entry (Textbook page 181) The equilibrium (or profit-maximising) position of a Monopolist We assume that the monopolistic firm aims to maximise profit. - A monopolist should produce where marginal revenue (MR) is equal to marginal cost(MC) (the profit- maximising rule), provided that average revenue (AR) is greater than minimum average variable cost (AVC) in the short run or average total cost AC in the long run (the shut-down rule). – Total , average and marginal revenue under © VAN SCHAIK PUBLISHERS  Monopol y The equilibrium (or profit-maximising) position of a monopolist Table 11-1 Average, total and marginal revenue when the demand curve for the product of the firm slopes downward: a numerical example (Textbook page 182) Box 11-2 Marginal revenue and price elasticity of demand (Textbook page 185) © VAN SCHAIK PUBLISHERS  Monopol y The equilibrium (or profit-maximising) position of a monopolist – The short-run equilibrium of the monopolistic firm Figure 11-2 The short-run equilibrium of the firm under monopoly (Textbook page 184) – The long-run equilibrium of the monopolistic firm absence of a supply curve under monopoly © VAN SCHAIK PUBLISHERS  The short-run equilibrium of the monopolist firm AR is the firm’s demand curve and it is downward sloping. MR is lower than AR and lies halfway between the price axis and AR. The firm maximises its profit where MC =MR, Point E at quantity Q1. At lower levels than Q1, MR > MC, meaning that the firm can add their profit by expanding their production. A monopolist firms sell their output at the price that consumers are willing to pay for that particular quantity. In this diagram that’s M1 on the demand curve at equilibrium price P1. Economic profit is the difference between M1 & K1 or the difference between P1 & C1. © VAN SCHAIK PUBLISHERS  Monopol y Monopoly © VAN SCHAIK PUBLISHERS  The Long-run equilibrium of the monopolist firm In monopoly, entry is blocked. Meaning that, short run economic profits cannot be reduced by firms entering the industry. Monopolist firms continue to earn economic profits in the long run as long as demand remains intact. There is no supply curve under monopoly. Under monopoly, a firm choose the combination of price and output at which profit is maximised (or loss minimised), given the demand (or revenue) conditions and the cost conditions. Monopolist firms are price makers and does not move along a supply curve as the price of the product changes. © VAN SCHAIK PUBLISHERS  Price Monopol y discrimination Price discrimination occurs only when price differences are based on different buyers’ valuations of the same product. If price differences are based on cost differences they are not discriminatory. Not all firms are in a position to practise price discrimination. Two basic conditions have to be met: 1. The firm must be a price maker or price setter. Under perfect competition, where all firms are price takers, price discrimination is impossible. 2. Consumers or markets must be independent. Consumers obtaining the product at a low price of in the low-priced market must not be able to resell the product at higher prices or in the high-priced market. The discriminating firm must be able to divide the market and keep the different parts separate. – First-degree price discrimination-occurs when each consumer is charged the maximum price he or she is prepared to pay for each unit of the product. – Second-degree price discrimination- occurs when the firm charges its customers different prices according to how much they purchase. I.e Netflix – Third-degree price discrimination- occurs when consumers are grouped into two or more independent markets and a separate price is charged in each market. I.e Eskom or Pharmacy © VAN SCHAIK PUBLISHERS  The Natural Monopoly firm A situation that occurs when it is most cost efficient for a single firm to produce all the output in an industry or market. Natural monopoly exist if AC is still declining when the quantity demanded reaches a minimum. Even if the price is zero, market demand will not be sufficient for the firm to achieve minimum AC. Now, there is a need for government intervention. Either government can produce the good itself or production could be left to a private firm, which is then regulated by government. Government will regulate through price © VAN SCHAIK PUBLISHERS  Monopol y Natural monopoly Figure 11-3 Natural monopoly (Textbook page 187) © VAN SCHAIK PUBLISHERS  The Pricing options under Monopolyfirm If the monopoly is unregulated, equilibrium will be at P1 and Quantity Q1. Marginal cost pricing- practice of setting the price of a product to equal the extra cost of producing an extra unit of output. P = MC Marginal cost pricing will yield a price P3 and quantity Q3 but the firm will make a loss. Because AC > MC, AC > AR Average cost pricing – setting the price of the product to equal AC Here, the firm covers its total costs. Price is higher than MC. The firm is producing where the AC intersect the demand curve. © VAN SCHAIK PUBLISHERS  Monopol y Natural monopoly Figure 11-4 Pricing options under natural monopoly (Textbook page 187) © VAN SCHAIK PUBLISHERS  Monopolistic competition Monopolistic competition is a market structure that characterises an industry in which many firms offer products or services that are similar, but not perfect substitute. Monopolistic competition combines certain features of monopoly and perfect competition. In a monopolistically competitive market, a large number of firms produce similar but slightly different products. Whereas both a monopolist and a perfectly competitive firm produce a homogeneous (standardised, identical) product, monopolistically competitive firms produce heterogeneous (differentiated) products. The act of making a product that is slightly different to the product of a competing firm is called product © VAN SCHAIK differentiation. PUBLISHERS  Monopolistic competition Product differentiation  Most products are not regarded as absolutely identical by all consumers.  When there are different varieties of a product, the product is called a differentiated (or heterogeneous) product.  In some cases different varieties of a product are technically different.  In some cases the contents of two different products may actually come from the same source.  Some consumers regard the products as identical and purchase the cheapest one. Others prefer the well-known brands and are therefore willing to pay a higher price to obtain them. Salient features of monopolistic competition The conditions for monopolistic competition can be summarised as follows:  Each firm produces a distinctive, differentiated product.  Each firm therefore faces a downward-sloping demand© VAN SCHAIK curve PUBLISHERS for its  Monopolistic competition The equilibrium of the firm under monopolistic competition Figure 11-5 The equilibrium of the firm under monopolistic competition (Textbook page 191) © VAN SCHAIK PUBLISHERS  Monopolistic competition The equilibrium of the firm under monopolistic Figure 11-5 The equilibrium of the firm undercompetition monopolistic competition continued © VAN SCHAIK PUBLISHERS  Oligopoly Under oligopoly a few large firms dominate the market. The product may be homogeneous, but it is mostly heterogeneous. When the product is homogeneous, the market is described as a pure or homogeneous oligopoly, and when the product is heterogeneous (or differentiated) the market is called a differentiated oligopoly. They engage in competitive advertising. They engage in brand marketing. They try to convince consumes that their product is better. The firms can influence the price of the product and quantity sold. © VAN SCHAIK PUBLISHERS  Oligopoly The main feature of oligopoly is: 1. The high degree of interdependence between the firms. Interdependence refers to the degree to which the actions of one firm affect (or are determined by) the actions of other firms. the decision of one firm influences and are influenced by the decision of other firms in the market. Under oligopoly there are so few suppliers that each firm is affected by the actions of the other firms. They take into account the likely reactions of their competitors. 2. Another feature of oligopoly is uncertainty. This is related to the interdependence among the firms. Because the firms are interdependent and no firm can ever be certain of the policies of its competitors, the firms operate in an uncertain © VAN SCHAIK environment. PUBLISHERS Barriers to entry Firms may not be able to enter the industry because of: a) Economies of scale b) Limit pricing c) Control over the channels of distribution d) Brand proliferation Examples???  Research!!!! Look at the household products in your own home to see what company produces them.  Oligopoly In an oligopolistic industry or market each firm must act strategically, since its profit depend not only on its own actions but also on the other firms’ actions. An oligopolistic firm must therefore always consider the possible impact of its decisions on the decisions and actions of its rivals each firm must constantly take strategic decisions. Oligopolists have two possible broad strategies: 1. They can join forces and act as if they were a monopolist (the collusion option) 2. They can compete with their rivals to gain a larger share of industry profits for themselves (the competition option).. © VAN SCHAIK PUBLISHERS  Oligopoly Strategy Collusion Is an agreement among firms to divide the market, set prices, or limit production.  The number of firms must be small and they must be well known to each other.  The firms should have similar production methods and average costs and therefore have an incentive to change prices at the same time by the same percentage.  The product should be homogenous rather than heterogenous, making it easier to agree on price.  There should be barriers to entry which reduce the possibility of disruption by new firms. © VAN SCHAIK PUBLISHERS  Oligopoly Strategy - Competition  Oligopolists compete in the form of non-price competition such as product development, advertising and other forms of marketing.  Non-price competition: when competing firms try to increase sales/market share by methods other than changing prices.  Price competition tends to be avoided, since price competition will drive down the average industry profit.  The more fiercely firms compete to obtain a larger share of industry profits, the smaller these industry profits will become. Non-price competition-  Branding: To create loyalty and recognition.  Packaging: Distinctive to competitors. © VAN SCHAIK PUBLISHERS  Oligopoly Oligopoly has a kinked demand curve. Kinked demand curve is defined as the demand curve of the individual firm in oligopolistic market. It has a “kink” at the existing price caused by the firm’s expectation of the actions its rivals are likely to take if the firm changes its price. It shows the importance of interdependence and uncertainty in oligopolist markets. © VAN SCHAIK PUBLISHERS Kinked Demand Curve Elastic demand curve increase in price, lose many customers A Price D = AR P1 B Inelastic demand curve decrease in price, gain few customers C Q1 Quantity  Explanation of Kinked Demand Curve Assumption: Price is P1 and Quantity is Q1, shown by point a which is a point of the demand curve. For oligopolistic firms, the outcome of the changes in price depend son the reaction of its competitors. Here the demand curve is Dd and it has a kink at the prevailing price OP1. The upper portion i.e. Da is elastic and the lower portion da is inelastic. The elasticity difference between two portions emerges because of differential reaction of the firms following a price rise or fall. The upper portion is elastic because if any one firm increases the price above the prevailing one, no other firm will follow him. So his product will become relatively more expensive, and he would lose a significant portion of his sales. The lower portion is inelastic because if any one firm © VAN SCHAIK reduces the price below the prevailing one, all other firm PUBLISHERS  Oligopol y No general theory of – An example of a theory of oligopolistic oligopoly behaviour: the kinked demand curve Figure 11-6 The kinked demand curve (Textbook page 194) © VAN SCHAIK PUBLISHERS  Oligopoly Thus, if a firm raises the price no other will follow him and he will hugely lose. So he would be reluctant to raise the price But if he lowers the price, the other firms will quickly follow the suite and his gain will be very less. So there is little incentive to reduce the price. Due to reluctance among firms either to reduce the price or raise the price, the price mostly remains sticky at the prevailing rate. The demand curve for the product of the firm is also its AR curve, and its MR curve lies halfway between the AR curve and the price axis. However, because the demand curve is kinked, the MR curve has 2 portions: MR (corresponding to Da) and mr (corresponding to ad). It is constant between R and m. © VAN SCHAIK PUBLISHERS  Oligopol y Advertising and product diversification as barriers to Entry Oligopolistic firms often use advertising and product diversification to create barriers to entry. Some firms spend huge amounts on advertising to create product awareness and loyalty to well- known brands thereby making it very expensive for potential rivals to enter the market. Product diversification can also be used as a barrier to entry. In many industries the existing firms produce multiple brands of the same product aimed at different market segments, which compete actively against each other as well Box 11-6 Advertising as against (Textbook the products of other firms. © VAN SCHAIK PUBLISHERS  Comparison of monopoly and imperfect competition with perfect competition Monopoly versus perfect competition A supply curve shows the quantity that producers are willing to supply for any given market price. A competitive firm: takes P as given has a supply curve that shows how its Q depends on P. A monopoly firm: is a “price-maker,” not a “price-taker” chooses a profit-maximizing quantity, taking into account its own ability to influence the price. Q does not depend on P; rather, Q and P are jointly determined by MC, MR, and the demand curve. So there is no supply curve for monopoly.  Comparison of monopoly and imperfect competition with perfect competition Monopoly versus perfect competition Figure 11-7 Comparison between monopoly and a perfectly competitive industry (Textbook page 198) © VAN SCHAIK PUBLISHERS  Comparison of monopoly and imperfect competition with perfect competition Monopoly versus perfect competitio AR is the demand curve for the product of the industry. MR is the monopolists' marginal revenue. MC is also a supply curve S for the perfect competitive industry. The long run equilibrium Ec for the perfect competition is established by the interaction of demand AR and Supply S at price PC and quantity Qc. Equilibrium for the monopolists is at Price Pm and quantity Qm. Under monopoly, the equilibrium price is higher and the equilibrium quantity is lower than under perfect competition. © VAN SCHAIK PUBLISHERS  Comparison of monopoly and imperfect competition with perfect competition Monopoly versus perfect competitio Figure 11-8 Comparison between monopoly and perfect competition if monopolistic firm has a lower cost structure (Textbook page 198) © VAN SCHAIK PUBLISHERS  Comparison of monopoly and imperfect competition with perfect competition Social costs of monopoly power Monopoly and perfect competition can be compared/contrasted by using consumer surplus and producer surplus (i.e. by using economic welfare/societal welfare measures). Consumer surplus is the amount a buyer is willing to pay for a product minus the amount the buyer actually pays. Consumer surplus is the area below the demand curve and above the market price.  A lower market price will increase consumer surplus.  A higher market price will reduce consumer surplus. Producer surplus is the amount a seller is paid for a product minus the total variable cost of production. Producer surplus is equivalent to economic profit in the long run. © VAN SCHAIK PUBLISHERS  Comparison of monopoly and imperfect competition with perfect competition Social costs of monopoly power Using the information in the previous slide, lets determine the social cost of monopoly power: For PC, output will be set at P = MR = MC Recall that for PC: MR=AR=Demand Price is Pc Recall that for monopoly, MR is not = Demand Output is set where MC = MR The monopoly output is less than the perfectly competitive output (The monopoly price is higher than the perfectly competitive price.) Consumers lose areas A and B Area A becomes the producer surplus, while B is simply lost. Area C which is part of the producer under perfect competition is also lost B + C is the total deadweaight loss © VAN SCHAIK PUBLISHERS  Comparison of monopoly and imperfect competition with perfect competition Social costs of monopoly Figure power 11-9 The social costs of monopoly (Textbook page 199) © VAN SCHAIK PUBLISHERS  Comparison of monopoly and imperfect competition with perfect competition Is monopoly a bad thing? – Some popular misconceptions about monopoly o Monopolist can charge virtually any price it wants. Not true o A monopolist will charge the highest price it can get. Not true o Monopoly guarantees economic profits (in the short run and in the long run). Not guaranteed o It is believed that once a profitable monopoly is established, its position is virtually unassailable and that it therefore has almost absolute economic power. Not true – The case against monopoly (or bigness) o Monopoly output is lower than perfectly competitive output and monopoly price is higher than perfectly competitive price, o There is little or no incentive for innovation or technological improvement under monopoly. o It leads to managerial inefficiency o Monopolists do not pay sufficient attention to the quality of their products or their service to customers. © VAN SCHAIK PUBLISHERS  Monopolistic competition versus perfect competition There is no difference between monopolistic competition and perfect competition in the long run equilibrium. The long run equilibrium only occurs if when normal profits are made. However, in the long run equilibrium, monopolistic competitive firms produce where price is higher than MC and where AC is not at a minimum. So monopolistic competition is neither allocative efficiently nor productive efficiently.  Comparison of monopoly and imperfect competition with perfect competition Monopolistic competition versus perfect Figure competition 11-10 Long-run equilibrium of the firm under perfect and monopolistic competition (Textbook page 201) © VAN SCHAIK PUBLISHERS  Monopolistic competition versus perfect competition The assumption is that both firms have the same long-run average cost curve LRAC. Dc is the Demand curve for perfect competitive firms. Pc and Qc is the quantity and price for perfect competitive firms. The perfectly competitive firm will produce quantity Qc at price Pc. Dmc is the demand curve for monopolistic competitive firms. Their price and quantity is Pmc and Qmc. The monopolistically competitive firm will produce quantity Qmc at price Pmc. Under monopolistic competition the price is higher and the quantity lower than under perfect competition. Monopolistically competitive firms do not produce where LRAC is at a minimum. The only way in which allocative and productive efficiency can be achieved is to standardise the  Oligopoly versus perfect competition - oligopolistic competition is much more active than perfect competition. Oligopolistic competition is an active, strategic process of moves and countermoves, in which one firm’s gains are often at the expense of the other firms in the industry. - However, perfect competition is entirely passive. Each firm is so insignificant that no one of them takes into account what the other individual firms do. - But as much as its passive, it is effective and prevents a perfectly competitive firm from “exploiting” consumers. - Comparing oligopoly is much better when they are in collusion and jointly maximise profits, they will in effect be acting together as a monopoly and all the disadvantages of monopoly will also be experienced under oligopoly  Policy with regard to monopoly and imperfect competition Government interventions to reduce supernormal profits, achieve a more efficient allocation of resources or to prevent abuse of market power when monopolist or oligopolist prevail. Government can also levy taxes on the firms concerned to reduce their profits. Government ownership: Nationalisation Regulation: laws, rules and regulations to control prices. Competition policy: government promotes competition by opening up the economy to imports Competition policy has three basic aims: 1. To prevent existing monopolies and other powerful firms abusing their power (monopoly policy). 2. To regulate the growth of market power through mergers and acquisitions (merger policy) 3. To prevent the application of restrictive practices, by © VAN SCHAIK PUBLISHERS  Important concepts Monopoly Demand for the Imperfect product of the firm competition Market conduct Monopolistic Natural monopoly competition Economies of scale Oligopoly Patents Market structure Licensing Homogeneous Predatory pricing (identical) Total revenue (TR) products Average revenue Heterogeneous (AR) (differentiated) Marginal revenue products (MR) Price takers Short run © VAN SCHAIK Price makers (price PUBLISHERS  Important concepts Total cost (TC) Allocative Average cost (AC) efficiency Marginal cost Productive (MC) efficiency Economic profit Deadweight loss Normal profit X-inefficiency Economic loss Rent-seeking Price Countervailing discrimination power Consumer surplus Regulation Product Competition differentiation policy Non-price Mergers competition Interdependence Advertisi Uncertainty ng © VAN SCHAIK PUBLISHERS