Block 4 Micro - Apuntes PDF

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MICROECONOMICS

Block 4. Imperfect Competition 4.1. Monopoly 4.2. Monopolistic competition 4.3. Oligopoly

Types of Market Structure · Principal Models of Market Structure:

- Perfect Competition - Imperfect Competition · Monopoly · Oligopoly · Monopolistic Competition · Imperfect Competition: Situations where producers/sellers have some market power to influence the market price. It implies one or more of the following characteristics:

- Relatively small number of companies - A differentiated product - Limited entry to the industry Features of the Monopoly · A monopolist is a firm that is the only producer of a good that has no close substitutes (unique product). An industry controlled by a monopolist is known as a monopoly. · The ability of a monopolist to raise its price above the competitive level by reducing output is known as market power → “price- maker”. · A monopolist has market power, and as a result will charge higher prices and produce less output than a competitive industry. - This generates profit for the monopolist in the short run and long run. · Profits will not persist in the long run unless there is a barrier to entry. This can take the form of:

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Control of natural resources or inputs Increasing returns to scale Technological superiority Government-created barriers: · Patents and copyrights · State Concession

- Elimination of competition: · Mergers and/or acquisitions

· Holdings & Trusts · Tacit or explicit collusion (cartel)

Characteristic of MONOPOLY · Concurrency: many consumers and only one producer (the monopolist) · Free Market, (regulation is recommended). · Closed Market, ∃ barriers to entry. · ∃ Market Power  “price-maker” and Price Discrimination · Unique Product (No substitutes) · Complete Information · ∃ Normal Profits in Short-Run and Long-Run ∃ Economic Profits in Short-Run and Long-Run

Economies of Scale and Natural Monopoly · A natural monopoly exists when increasing returns to scale provide a large cost advantage to a single firm that produces all of an industry’s output. · It arises when increasing returns to scale provide a large cost advantage to having all of an industry’s output produced by a single firm. · Under such circumstances, average total cost is declining over the output range relevant for the industry. · This creates a barrier to entry because an established monopolist has lower average total cost than any smaller firm.

Natural Monopoly “an industry in which the production level, whatever that may be produced cheaper by one company that by two or more firms” Cause:

- Economies of Scale and Scope  decreasing ATC (High Fixed Costs) (e.g., nets)

Natural Monopoly (Decreasing ATC)

Comparing Demand Curves

Total Revenue (TR), Average Revenue (AR) and Marginal Revenue (MR)

Demand, TR, AR, MR

Profit-Maximizing Rule

Monopoly Profit

Persistence of long-term economic benefits of the monopolist - Closed Market  ∃ BARRIERS TO ENTRY · Control of natural resources or inputs · Increasing returns to scale · Technological superiority · Government-created barriers including patents and copyrights

- Intervention and/or government regulation or monopoly

Natural Monopoly: ∃ Economies of Scale and Scope

Measurement of Monopoly Power - LERNER INDEX (Abba Lerner) IL = (P -MC) / P If IL = 0 then, the firm is perfectly competitive If IL > 0 then, there is market power (monopoly power)

- HERFINDHAL INDEX (Orris Herfindahl) IH = Σ si2 (i = 1,2, … n) Where n is the number of firms in the industry and si the market share of each firm. Then, 1/n PPC

- Loss of efficiency in the monopoly

- Determining the level of production

- Economic benefits

- Efficiency and Social Welfare

Efficiency and Social Welfare

Inefficiency of Monopoly The loss of efficiency or inefficiency is due to the production level is lower than under competitive conditions (irretrievable loss of efficiency). In addition, the economic benefits of monopoly meant a cut in consumer surplus and producer surplus increases.

Perfect Competition vs. Monopoly

Consequences of monopolies · The power of monopoly implies that the price is higher than marginal cost, so this causes a worsening consumer welfare and enterprises don’t improve. · There is also an efficiency loss when the monopolist must devote resources to maintain their position of power, monitor the emergence of possible competitors, get legal franchises, …

· The social cost that cause monopolies imply to move on governments to act to try to remove them  LIBERALISATION OF MARKETS (F Privatization of public monopolies) · “Monopolies are a major engine of economic growth, because due to the great economic benefits, the attraction to enter the market makes no one monopoly lasts forever” (Joseph Schumpeter)

Price Discrimination · Sell a product at a difference price depending on the consumer and/or depending on the number of units sold. You can do this only in the first stage of the product. Requirements: - Typology of consumers must be identifiable and separable. - The resale must be difficult · These price differences are not caused by differences in production costs.

The Logic of Price Discrimination · In fact, monopolists find that they can increase their profits by charging different customers different prices for the same good. · Price discrimination is profitable when consumers differ in their sensitivity to the price (different price elasticity) -

It is profit-maximizing to charge higher prices to low-elasticity consumers and lower prices to high-elasticity consumers. When the demand is more elastic, I’m going to apply a lower price, and when the demand is more inelastic, I’m going to apply a higher price.

Price Discrimination, the form to implement the Market Power -

The Third-Degree Price Discrimination, price varies by the individual or collective customer’s identity.

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The Second-Degree Price Discrimination: price varies according to quantity demanded.

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The First-Degree Price Discrimination or Perfect Price Discrimination: requires knowing the absolute maximum price that every consumer is willing to pay. CS is 0. All the consumer surplus goes to producers.

Third Degree Price Discrimination · The seller distinguishes the different consumer groups, setting a different price for each group or collective.

E.g., Young Card, old-age pensioner, students UB, … E.g., Airfares

E.g., Professions (prices based on income)

Second-Degree Price Discrimination · The unit price varies depending on the amount purchased, but not on identity of the consumer (volume discounts) E.g., Buy 1 get the 2nd Free One, Two, Free! (Buy 2 get the 3rd free) 1 kg – 1,00€; 3 kg. – 2,50€ 1 drink = 10€, 3 drinks = 20€

First-Degree Price Discrimination or Perfect Price Discrimination · Perfect price discrimination takes place when a monopolist charges each consumer according to his or her willingness to pay – the maximum that the consumer is willing to pay. · Perfect price discrimination is probably never possible in practice.  The inability to achieve perfect price discrimination is a problem of prices as economic signals because consumer’s true willingness to pay can easily be disguised.

· The seller sets different prices for each consumer and for each unit purchased, extracting all consumer surplus. · There is no deadweight loss. From the point of view of efficiency, when a monopoly practices such discrimination has the same result as perfect competition. · Perfect Price Discrimination does not occur in the real world.

Public Policy about Monopolies -

Doing nothing (Unregulated – Market Deregulation and/or Introduction of Competition)

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Antitrust policies: antitrust laws (to prevent or eliminate monopolies and to reduce market power: max. market shares, forced disinvestments, forbidden concentrations, fines or financial penalties…)

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Public ownership (nationalization)

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Price regulation: price ceiling (price ceiling on a monopolist, as opposed to a perfectly competitive industry, need not cause shortages and can increase total surplus)

Regulatory Options · Unregulated · Price Efficiency · Production Efficiency · Profit Regulation Monopoly vs. Natural Monopoly

· Unregulated (point A) · Average Cost Pricing (point C) P = CMi  Deadweight Loss · Marginal Cost Pricing (point B) P = CMg a) Subsidies b) Benefits

Monopoly Regulation

Natural Monopoly Regulation

Oligopoly “Market structure where most of the production and/or sales are made by few companies and each one is able to influence on the market price (market power)”. “Interdependence: the actions and decisions of a company affect and are affected by the actions and decisions of other firms”.

Features of the Oligopoly · Oligopoly is a common market structure. - It is a weaker form of monopoly. - It is an industry with only a small number of producers (oligopolists). - An oligopoly consisting of only two firms is a duopoly. Each firm is duopolistic. · In Oligopolies, firms compete but possess market power. Oligopolists are “pricesearches”. · Few sellers offering similar or identical products, but differentiated via advertising, brands, design, … · The key feature of oligopoly is the tension between cooperation and self-interest.

Characteristics of Oligopoly · Concurrency: many consumers and few producers (oligopolists) · Free Market. · Closed Market, ∃ barriers to entry · ∃ Market Power  “price-searchers” · Differentiated Product · Interdependence and strategic behaviors · Complete information · ∃ Normal Profits in S/R and L/R ∃ Economic Profits in S/R and L/R

Interdependence · Cooperative behavior -

Informal Collusion or Tacit Collusion (without a formal agreement) Formal Collusion: CARTEL

· Noncooperative behavior -

NONPRICE COMPETITION · Quantity competition (Cournot model)

· Advertising competition -

PRICE COMPETITION (price war or tacit collusion) · Price competition (Bertrand model) · Price leadership (differentiated products)

· The key feature of oligopoly is the tension between cooperation and self-interest. The study of behavior in situations of interdependence is known as game theory. · A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

The Games Theory John von Neuman (mathematician) and Oscar Morgenstern (economist)ç The Prisoner’s Dilemma: “Two robbers, Blake and Reid, are caught robbing a bank, a crime that had been committed many times before. Locked in two separate cells from prison, they are made the same proposal to both "two years in prison for the robbery that you did last night. But if one of you confesses all robberies that have made, reduced the sentence to one year, while another eight years in prison. If both confess, the sentence shall be five years each. You have one hour to decide ". The question is…

Cooperative vs. Defect · The game is based on two premises: 1) Each player has an incentive to choose an action that benefits itself at the other player’s expense. 2) When both players act in this way, both are worse off than if they had acted cooperatively. · But if a game is played repeatedly, players may engage in strategic behavior, sacrificing S/R profit to influence future behavior. · In repeated prisoners’ dilemma games, tit-for-tat (TFT strategy) is often a good strategy, leading to successful tacit collusion.

Dominant strategy and Nash equilibrium · An action is a dominant strategy when it is a player’s best action regardless of the action taken by the other player. · A Nash equilibrium, also known as a noncooperative equilibrium, is the result when each player in a game chooses the action that maximizes his or her payoff given the actions of other players, ignoring the effects of his or her action on the payoffs received by those other players.

The Prisoner’s Dilemma

Matrix of benefits (payoff matrix)

The Kinked Demand Curve · An oligopolist who believes he will lose a substantial number of sales if he reduces output and increases her price but will gain only a few additional sales if he increases output and lowers his price away from the tacit collusion outcome, faces a kinked demand curve—very flat above the kink and very steep below the kink. · It illustrates how tacit collusion can make an oligopolist unresponsive to changes in marginal cost within a certain range when those changes are unique to his.

Oligopoly Conclusions · If oligopoly firms pursue their own self- interests (without collusion): 1. Joint output is greater than the monopoly quantity but less than the competitive industry quantity. 2. Market prices are lower than monopoly price but greater than competitive price. 3. Total profits are less than the monopoly profit.

Monopolistic Competition · Monopolistic competition is a market structure in which -

There are many competing producers in an industry. Each producer sells a differentiated product. There is free entry into and exit from the industry in the long run.

· Product differentiation is the only way monopolistically competitive firms can acquire some market power (elastic demand).

Characteristics of Monopolistic Competition · Concurrency: many producers and many consumers · Free Market · Open Market, ∃ barriers to entry · Light Market Power → elastic demand function · Differentiated Product · Complete Information · ∃ Normal Profits in Short-Run and Long-Run ∃ Economic Profits in Short-Run ∃ Economic Profits in Long-Run

Product Differentiation · Each firm produces a product that is at least slightly different from those of other firms. · Rather than being a price taker, each firm faces a downward-sloping demand curve. · Value in diversity. · Forms of Product Differentiation - Differentiation by style or type. - Differentiation by location.

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Differentiation by quality. Some firms create brand names.

A Monopolistic Competitive Firm in the S/R

Entry and Exit Shift Existing Firm’s Demand Curve and Marginal Revenue Curve

The L/R Zero-Profit Equilibrium (zero-profit equilibrium and excess of capacity)

Monopolistic Competition vs. Perfect Competition · In the long-run equilibrium of a monopolistically competitive industry, there are many firms, all earning zero profit. · P > MC; Price exceeds marginal cost, so some mutually beneficial trades are unexploited. · Firms in a monopolistically competitive industry have excess capacity: they produce less than the output at which average total cost is minimized. P = ATC but, P F minimum ATC. · This is actually a source of inefficiency (?)

Comparing L/R Equilibrium in Perfect Competition and Monopolistic Competition...