Duffy’s Notes

1. Duffy’s Notes Market Structures

2. Theories of Imperfect Competition Industrial organization is the study of the behavior of imperfectly competitive industries. In this class, we will look at some of the possible organizations.

3. Different Possibilities • Perfect Competition (many small firms that produce an identical product, price takers) • Monopoly (one firm, market demand = firm’s demand) • Oligopoly (a few firms, which may produce identical products or branded products) • Monopolistic competition (many producers of similar, but not identical products. Branded products with easy entry and exit.)

4. Products Aircraft Batteries Cigarettes Electricity Appliances Wheat Breakfast cereals Which markets are characterized by many small firms producing an identical product?

5. The U.S. economy In the United States, perhaps the majority of products are produced in industries where there are only a few major firms and/or where products carry brand names. One notable exception is agricultural products.

6. Imperfect Competition Imperfect Competition prevails in an industry whenever individual sellers have some measure of control of their output price.

7. Graphical Depiction Firm Level Demand Curves perfect competition imperfect competition p p d d q q

8. The Level of Control Imperfect competition does not mean that a firm has absolute control over price. If a product with many substitutes (or even one close substitute) is priced well above the substitutes, few if any consumers will buy it.

9. Why do we have imperfect competition? • Economies of size. • Barriers to entry. • Branded products with differences in characteristics of the products.

10. Barriers to Entry Some industries are difficult to enter. They may, for example, require a very large initial capital outlay, or there may be legal restrictions limiting the number of firms.

11. Legal Restrictions Governments sometimes restrict competition through patents, entry restrictions, and foreign trade tariffs and quotas.

12. Entry Restrictions Governments may restrict entry for a variety of reasons. Some towns limit the availability of liquor licenses because they want to limit the number of establishments serving alcohol. Some cities restrict the number of taxi-cab drivers to avoid excess congestion caused by too many cabs in the downtown area.

13. Import Restrictions Governments may restrict imports to keep out foreign competitors.

14. High Cost of Entry An economic barrier to entry occurs if an industry requires a high initial capital outlay, as is the case in the aircraft industry. Or the new industry might have to overcome strong consumers habits (such as occur from using one brand of software) via an expensive advertising and education campaign.

15. Advertising and Barriers to Entry Firms can use advertising to make it difficult for new firms to enter a market. Advertising is used to differentiate products (e.g. soda brands) and build up brand loyalty. In some industries, a small number of producers make a vast array of different branded products.

16. Patents Q: Why do governments restrict competition through granting patents on new inventions, such as new drugs or machines? A: Without patent protection, firms or individuals would have little incentive to devote time and resources to making these discoveries.

17. Economies of Size Economies of size mean that firms can reduce their average costs as they grow larger. When there are economies of size in an industry, competitive pressures will favor the survival of the larger, lower-unit-cost firms.

18. Remember the Average Cost Curve economies of size AC q

19. Firms will Firms will benefit from reduced average costs by expanding their output up to the point where AC is at a minimum. If this point occurs at a relatively low output level (relative to the demand for the product), the industry will be characterized by many firms. If this point occurs at a high output level, relative to demand, the industry will have few firms or perhaps only one firm.

20. Because of the shape of the AC curve, this industry would likely be a monopoly. AC minimum AC curve (firm) D (market) quantity

21. A Natural Monopoly • A natural monopoly is one that arises because of economies of size. • The AC is always decreasing (up to any point necessary to cover the market’s entire demand). • If AC is decreasing, MC is less than AC. • For AC to be always decreasing, there must be high fixed costs and low variable costs. AFC always decline as output increases.

22. Utilities and Natural Monopolies In the early decades of this century, utilities were almost all natural monopolies. Recent technological changes have changed the cost structure in many of these industries, however. Most of the U.S. population can pick from at least two cellular phone companies, for example, and a variety of long-distance services.

23. Because of the shape of this AC curve, this industry would likely be an oligopoly. AC curve (firm) D (market) quantity

24. Because of the shape of this AC curve, this industry would likely have many firms. D (market) AC curve (firm) quantity

25. Will increased competition always result in lower prices? It is widely believed that increasing competition (number of firms in the market) will always result in lower prices to consumers. In reality, we must first look at the cost structure in an industry to say if having more firms in the industry would actually result in lower prices.

26. Monopoly • Under monopoly there is one and only one firm in the market. • The market demand curve is the firm’s demand curve. • If the monopoly increases output, price falls. • If the monopoly decreases output, price increases. • A monopoly firm, seeking to maximize profit must recognize that its output level affects price.

27. The Monopoly The monopoly has the same profit equation as the competitive firm. The difference is that in this case, the price of the output is not fixed to the firm but determined by the firm’s output level. Profit = TR – TC

28. Marginal Revenue Again Marginal Revenue is the increase in revenue from producing and selling one more unit of output. Because a competitive firm does not affect price with its output, MR in that situation was just output price. For the monopolist, however, output does affect price, so Marginal Revenue is not fixed.

29. Demand The demand curve faced by a monopolist is the market demand curve. We know that a market demand curve is downward sloping, hence as monopoly output increases, price would fall.

30. Total Revenue p Total Revenue is Price * Output d q = Q

31. Marginal Revenue Because price falls as output increases, MR for a monopolist must be found by taking the change in total revenue and dividing by the change in output. MR = TR Y ______

32. Example

33. Marginal Revenue • If demand is a straight line, then Marginal revenue will be positive for quantities that correspond to points above the midpoint of demand. • If demand is a straight line, Marginal Revenue is zero at the midpoint quantity. • If demand is a straight line, Marginal Revenue is negative at quantities corresponding to points below the midpoint.

34. Values of MR for a Monopolist Marginal revenue is positive when demand is elastic, zero when demand is unit elastic, and negative when demand is inelastic.

35. Marginal Revenue of a Monopolist The MR of a monopolist can be shown to be: MR = Py(1 - ) ____ 1 Ed Where Ed is the elasticity of demand.

36. P midpoint Demand Q Marginal Revenue

37. Monopoly and Ed • Monopolists will never produce in the range where MR<0. • They will have higher total revenue and lower total costs if they back up to the point where MR is not negative. • So monopolists will never produce in the inelastic range of demand.

38. Profit-Maximizing Point The profit-maximizing point for a monopolist occurs where MR= MC. In this case, not only quantity but price will be determined.

39. Steps Calculate MR and MC for each level of output. Find output level where MR=MC. Read price that corresponds to that output level from the demand curve.

40. Graph of profit-maximizing MC p* AC d MR q*

41. Profits for monopoly MC p* AC Profit is the pink rectangle. d MR q*

42. Monopoly Rents In a monopoly, price will always be higher than MC. Monopolies therefore often earn an “economic profit” (above opportunity costs). Sometimes these economic profits are called “monopoly rents.”

43. Calculating the impact of monopoly power • To calculate the impact of a monopoly power, economists like to compare the price the monopoly charges to marginal cost pricing, such as might be found under perfect competition. • To do that, they look at the point where the MC curve of the monopolist crosses the demand curve.

44. Graphing “monopoly rents” Draw a line from the vertical axis to the point where MC intersects demand. The portion of the profit above that line is monopoly rent. MC = demand MC p* AC d MR q*

45. Dead-weight loss. Dead-weight loss from a monopoly is the triangle to the right of the monopoly profits. MC p* AC d MR q*

46. Monopoly rent and dead-weight loss come from consumer surplus lost to monopoly. If the industry were competitive, price would equal MC. Consumer surplus would be the yellow triangle shown here. MC AC pc d qc

47. Under Monopoly, Consumer Surplus is smaller. The blue triangle is consumer surplus under monopoly. Part of the lost surplus is “monopoly rent.” Part is “dead-weight loss.” MC p* AC pc d q* qc

48. Breaking Up Monopolies In the case of monopolies that arise because of decreasing AC, we can’t say whether breaking up the company and replacing it with many small companies will result in lower prices to consumers because the small companies will not be able to take advantage of the economies of size.

49. Regulated Monopolies Governments may step in to regulate a monopoly. The intent is to ensure that economies of size are enjoyed by both the monopolistic firm and the consumers using its services.

50. Governments and Utilities Because utilities often have significant economies of scale, local governments may grant a franchise monopoly for service to an area. The firm is guaranteed a sufficient customer base to keep its AC low, and in turn the firm agrees to limit the price it charges to customers and to provide universal service.