Market Structures Vladimír Hajko 2016 Vladimír Hajko (FSS MU) Introduction to Economics 1 / 36 1 Competitive Markets Competitive markets 2 Imperfect competiton Monopoly Monopolistic Competition Oligopoly Vladimír Hajko (FSS MU) Introduction to Economics 2 / 36 Competitive Markets Outline 1 Competitive Markets Competitive markets 2 Imperfect competiton Monopoly Monopolistic Competition Oligopoly Vladimír Hajko (FSS MU) Introduction to Economics 3 / 36 Competitive Markets Competitive markets Features of a competitive market Simple reference model (real world seldom resembles it, but still useful) Many buyers and sellers with insignificant market shares Homogeneous product Everyone is a price-taker, insignificant market power (to change the price) of the participants No entry-barriers (firms can enter or exit the market freely in the Long-run) No information barriers (so that information and technology improvements can spread freely (no patents, copyrights etc.)) "Ideal situation" - efficient (recall the lecture on "Consumers, Producers and Efficiency of Markets") Vladimír Hajko (FSS MU) Introduction to Economics 4 / 36 Competitive Markets Competitive markets Variables (recall from Theory of Firms) Quantity produced (Q), Price (P) Costs Variable Costs (VC) - associated with quantity produced (the more we produce, the more it costs), usually cost of labor, every factor in the Long Term (LR) Fixed Costs (FC) - payed once in Short Run (SR) and cannot be spared (the more we produce, it costs the same), usually cost of capital Total Costs (TC): TC = VC + FC Average values of VC, FC and TC (AVC, AFC, AC) - AVC = VC Q , AFC = FC Q , AC = TC Q Marginal Costs (MC) - change of TC with additional Q, MC = δTC δQ Revenues Total Revenues (TR) - all items sold, TR = P.Q Average Revenue (AR) - AR = TR/Q Marginal Revenue (MR) - change of TR with additional Q, MR = δTR δQ Vladimír Hajko (FSS MU) Introduction to Economics 5 / 36 Maximizing Firm’s Profit Profit: π = TR − TC Firm maximize its profit when MC = MR ⇔ δTC δQ = δTR δQ Maximizing Firm’s Profit (Marginal Values) Short Run - Shut down decision when facing a loss Should the the firm shut down facing a loss? Short Run - Shut Down Decision Loss does not necessarily lead to shut down - if revenues cover at least variable costs (because fixed costs have to be paid anyway) anything above helps the firm pay a part of the fixed costs Firm’s Supply A link between price and quantity produced can be seen (recall Law of Supply) Competitive Markets Competitive markets Market Equilibrium There are no entry-barriers or information constraints in competitive market (insignificant transaction costs) When price is set (sellers are price-takers), only costs determine the profit Costs are determined by production function, i.e. technology But with free information exchange, every firm can acquire the best technology to achieve high profit! What happens? New producers (firms entering the market) increase the total quantity (even if they are small individually - the assumption of insignificant or no market power), which leads to decrease in the price (remember Supply and Demand) so that: P = AVC = MC = MR Vladimír Hajko (FSS MU) Introduction to Economics 11 / 36 Competitive Markets Competitive markets Market and Firm’s Equilibria in LR All firms produce at minimum AC (optimal - production efficiency) Vladimír Hajko (FSS MU) Introduction to Economics 12 / 36 Competitive Markets Competitive markets Changes in the short run Rising market demand increases price so producers are willing to produce more and make a profit Vladimír Hajko (FSS MU) Introduction to Economics 13 / 36 Competitive Markets Competitive markets Market Equilibrium in Oil Producers Market When efficiency throughout the industry is not the same (various AC), then final price doesn’t have to return to previous equilibrium There might be producers with substantial profits (e.g. Saudi Arabia) and no profits (e.g. Canadian oil sands) Vladimír Hajko (FSS MU) Introduction to Economics 14 / 36 Imperfect competiton Outline 1 Competitive Markets Competitive markets 2 Imperfect competiton Monopoly Monopolistic Competition Oligopoly Vladimír Hajko (FSS MU) Introduction to Economics 15 / 36 Imperfect competiton Monopoly Assumptions Monopoly represents a market with just one seller (and many buyers) (from Greek mónos ("sole") and p¯olé¯o ("I barter / I sell")) Seller (the monopolist) is a price-maker, buyer is a price-taker Significant market power of the monopolist (and insignificant market power of the individual buyers) Monopolist may set price and/or quantity produced - but still has to take the market demand into consideration in addition, presence of one seller in the market does not necessarily means the monopolist will exercise its market power (theory of contestable markets) Vladimír Hajko (FSS MU) Introduction to Economics 16 / 36 Imperfect competiton Monopoly Sources of a monopoly Natural monopoly based on the economies of scale (decraseing ATC) - i.e. two firms servicing whole market are less efficient than just one (typically network industries) Resource monopoly The monopolist own unique resource that noone else has Government-created granted by government power - determined by politics (e.g. railways); public interest (army, police), copyrights, patents Monopoly is difficult to maintain (apart from those granted by the government) - technological advance, competition, reverse engineering etc. Vladimír Hajko (FSS MU) Introduction to Economics 17 / 36 Imperfect competiton Monopoly Revenues Monopoly → market demand is the firm’s demand A monpolist faces downward-sloped (market) demand (P↑⇒Q↓) This demand equals monopolist’s AR (because each unit is sold at the same price) Vladimír Hajko (FSS MU) Introduction to Economics 18 / 36 Imperfect competiton Monopoly Profit Maximization Monopolist maximizes its profit when MR = MC (a monopolist behaves like any other firm - i.e. solves the problem: max Π = TR − TC) This solution generates Dead Weight Loss (DWL) (MR < AR ⇒ QM < Q∗ and PM > P∗) and Price of the product is higher than MC and AC (inefficient - additional quantity could be produced - but all units sold at the same price! Recall there is the output effect AND the price effect) Vladimír Hajko (FSS MU) Introduction to Economics 19 / 36 Imperfect competiton Monopoly Monopoly - Issues Government attitude towards monopolies Avoiding monopolies - antitrust laws Regulating natural monopolies Public ownership Price discrimination - Monopolist is able to sell at various prices (separate customers) - increase its profit and reduce DWL (but appropriating the consumer surplus) Vladimír Hajko (FSS MU) Introduction to Economics 20 / 36 Imperfect competiton Monopoly Price Regulation - Monopoly Price regulated exactly at P = AR = MC (and = MRreg ) which leads to DWL = 0 Monopolist’s profit depends on its AC Vladimír Hajko (FSS MU) Introduction to Economics 21 / 36 Imperfect competiton Monopoly Price Regulation - Monopoly Actual regulation lot more complicated! Difficult to observe MC for external subject Regulatory lag Red tape Costs of regulation Regulation can limit or inhibit innovation and growth Regulatory capture (close relationship between regulators and business) Vladimír Hajko (FSS MU) Introduction to Economics 22 / 36 Imperfect competiton Monopolistic Competition Overview Many sellers, many buyers (lot more realistic than both perfect competition and pure monopoly (depends how close substitutes are available)) Free entry (and exit) Product differentiation - each seller meets downward-sloped demand with its special product - but the slope is relatively low (which also means DWL is not as large) Price setting - similar to a monopolist’s BUT free entry → profitable markets attract new entrants (increasing market supply) new entrants reduce the demand for the particular product of the original firm → it shifts the demand curves faced by the incumbent firms to the left long-run profits tend to zero (like in competitive markets) - production not at minimum AC (but close) no incentives to enter for new firms + incumbents have no incentive to exit Vladimír Hajko (FSS MU) Introduction to Economics 23 / 36 Imperfect competiton Monopolistic Competition Overview Excess capacity (production efficiency below the optimum; production costs higher than technologically possible (minimum AC)) P > MC, so firms want new customers Advertising expenses (BUT certain theories can explain this - value of a brand as a sum of previous expenses - a commitment to maintain the quality - lower the quality to get a little more and you will lose much more "invested" in building the brand) There is non-zero DWL - some people value the production higher than MC (so they should be able to get it), yet lower than P (they won’t buy it) Examples: Books, Movies, Restaurants, Fashion, Shoes, Food etc. (+ marketing is all about product differentiation and product’s unqiue selling proposition) Vladimír Hajko (FSS MU) Introduction to Economics 24 / 36 Imperfect competiton Monopolistic Competition Profit and Equlibrium in LR Vladimír Hajko (FSS MU) Introduction to Economics 25 / 36 Imperfect competiton Oligopoly Overview Few sellers (with substantial market share, i.e. with significant market power) Each seller may set its production quantity and price, given the demand Product of each seller is similar if not the same (you can substitute the product from the other seller) Important: Action of one seller may have a large impact on the others Examples: Crude oil, Car makers, Aviation industry, Airlines. . . Popular oligopoly models (often simplified to duopoly): Bertrand and Cournot (see chap. 27 in Varian 2010) Bertrand competition: firms set prices and the consumers choose quantities at the prices set Cournot competition: firms set the amount of output (setting the output independently of each other and at the same time - no collusion) Vladimír Hajko (FSS MU) Introduction to Economics 26 / 36 Imperfect competiton Oligopoly Game Theory How people behave in strategic situations, i.e. anticipating how others will behave Firms in competitive markets (and monopolists) do not care about other firms - they were insignificant Firms in Oligopolies must take it into account ⇒ they are playing strategic game game theory explains their behavior Vladimír Hajko (FSS MU) Introduction to Economics 27 / 36 Imperfect competiton Oligopoly Prisoners’ Dilemma Two suspects under arrest deciding separately strategy for interrogation. Dilemma: Confess or Silence with different outcomes depending on others choice B Confess Silence A Confess 8 / 8 0 / 20 Silence 20 / 0 1 / 1 The best outcome (1/1) cannot be achieved even if players act in collusion - they risk long sentence + the other player can improve his situation by confessing Vladimír Hajko (FSS MU) Introduction to Economics 28 / 36 Imperfect competiton Oligopoly Dominant Strategy and Nash Equilibrium When there is a best solution for a player regardless of opponents choice it is called dominant strategy B Confess Silence A Confess 8* / 8* 0 / 20* Silence 20* / 0 1 / 1 In this particular game, dominant strategy for both players is to confess - this is called Nash equilibrium it is not necessarily the most efficient outcome, but definitely one that can be reached in strategic encounter If the first payoff number (row player) in the payoff pair of the cell is the maximum of the column of the cell AND if the second number (column player) is the maximum of the row of the cell → then the cell represents a Nash equilibrium Even though being silent ⇒less time spent in prison, precaution and self-interest (or simply assuming others moves) lead to opposite strategy (both confess) Vladimír Hajko (FSS MU) Introduction to Economics 29 / 36 Imperfect competiton Oligopoly Cartel Limited number of sellers on the market may deliberately (in collusion) decrease their output in order to increase the market price and their collective profit Sellers cooperate in order to act as a monopolist - and they maximize profit as such When the demand elasticity is low, price increase might be substantial Cartels generally frowned upon by law - extensive search for possible collusion and consequent bans and penalties Vladimír Hajko (FSS MU) Introduction to Economics 30 / 36 Imperfect competiton Oligopoly Cartel Cartel members seeking monopolist’s profit: Is this really the best solution for all cartel members? Vladimír Hajko (FSS MU) Introduction to Economics 31 / 36 Imperfect competiton Oligopoly Example Imagine two oil producers with no marginal costs (additional barrel is filled with oil spouting from the ground); total production capacity of each producer is 6 mbpd; demand schedule might look like this: Price ($/b) 0 10 20 30 40 50 60 70 80 90 Q (mbdp) 12 11 10 9 8 7 6 5 4 3 Profit (m$) 0 110 200 270 320 350 360 350 320 270 In comp. market with MC = 0 price would be 0 and all 12 mbpd would be produced. Monopolist would certainly choose Q = 6 with highes revenue/profit Duopolistic cartel face a dilemma: While producing 3 mbpd each with equal profit 180 m$ each producer is tempted to increase Qty With total production 7 mbpd divided 4:3, producer with higher share enjoy 200 m$ profit vs 150 m$ of the other Vladimír Hajko (FSS MU) Introduction to Economics 32 / 36 Imperfect competiton Oligopoly Oil Producers’ Game Iraq 3 4 Iran 3 180 / 180 150 / 200* 4 200* / 150 160* / 160* What quantity to produce? Two dominant strategies - to increase output (even if they decide to cooperate, there is an incentive to increase) It is difficult to maintain low production and high price - if we consider it as "one-shot" situation (a simultaneous game) Sequential games and repeated games yield different outcomes NOTE: cooperative games = the players are able to form binding commitments (externally enforced, e.g. by law) non-cooperative games = the players cannot make contracts OR if all agreements need to be self-enforcing (e.g. through credible threats) Vladimír Hajko (FSS MU) Introduction to Economics 33 / 36 Imperfect competiton Oligopoly Oil Producers’ Game - Cartel Cartels represnt non-cooperative games (can by only enforced by (credible) threats, not externally (by law)) Cartel can survive as long as punishments are harsh enough so that the benefits of deviation (not colluding) are smaller than the benefits of colluding (see folk theorem) - but it depends on: The credibility of the threat of such punishment The discount factor of individual members (see time value of money "a dollar today is better than a dollar tomorrow") Effective cartels: when the cartel can actually influence the price (increase the price) AND the demand is relatively stable Advantageous: inelastic demand and inelastic supply response of non-cartel members and producers of close substitutes Vladimír Hajko (FSS MU) Introduction to Economics 34 / 36 Imperfect competiton Oligopoly Oligopoly remarks Cartel members have incentives to cheat (for repeated game that is NOT infinite - it is rational to cheat in the "last round") There are coordination costs (e.g. time) Game Theory can be (successfully) apllied when inspecting oligopolies and cartels Comparison of oligopoly with a competitive market and monopoly: Price (P): CM < Oligopoly < Monopoly Quantity (Q): CM < Oligopoly < Monopoly Vladimír Hajko (FSS MU) Introduction to Economics 35 / 36 Imperfect competiton Oligopoly References Hal R. Varian. Intermediate Microeconomics. A Modern Approach. W. W. Norton & Company, 2010. Vladimír Hajko (FSS MU) Introduction to Economics 36 / 36