Market Power and Monopolistic Competition

1. Market Power and Monopolistic Competition Chapters 22 and 23.

2. Students should be able to: • Describe the conditions that characterize markets with monopoly, oligopoly, and monopolistic competition. • Differentiate perfect competition, monopolistic competition, and regulated and unregulated monopoly in terms of output and price relative marginal cost and or fixed costs. • Discuss types of barriers of entry, entry deterrence strategies and the consequences of uncontested markets. • Define price discrimination and discuss the costs and benefits to the firm and society. • Evaluate the difficulties of maintaining collusion

3. Market Power • Market power is the ability of a firm to affect the market price of a good to their advantage. In declining order. • Monopoly – A single producer without competition • Oligopoly Power – A small number of producers sometimes acting in concert. • Monopolistic Competition – Firms selling differentiated products.

4. Price effects • There is a demand curve relating the quantity of a product that can be sold at a given price. • Invert the concept: For each quantity, there is a price that the market may bare. • Change the quantity and change that price • Marginal revenue

5. Marginal Revenue • For price taking firm, marginal revenue is equal to price. • For a firm with market power, marginal revenue must include the change in the price that results from a change in quantity.

6. Example

7. Monopolist • Maximize Revenues by choosing an output level such that marginal revenue equals marginal cost. • Price will exceed marginal cost. Monopolists will make greater profits than a competitive firm. • Profits should attract new entrants to the market. • Monopoly can only survive if there are some barriers to entry.

8. Monopolist ATC D MC MR

9. Monopolist D ATC MC MR

10. Revenues Monopolist D ATC MC MR

11. Markups • If a market is competitive, then price will equal marginal cost. • Degree of market power is often measured as markup over marginal cost • For monopolist, the MR = MC The less elastic the demand curve, the higher the market power. Firm has more pricing power if good has fewer substitutes.

12. Lerner Index • Net markups are a measure of the market power of a firm or industry. Referred to as the Lerner index. • Rule of thumb for a monopolist, • If markups are below this level, raise prices. • If markups are above this level, lower prices.

13. Profits Monopolist D ATC MC MR

14. Profits Price Taker D ATC MC MR

15. Monopolist’s Schedule

16. Barriers to Entry • Total Control over Vital Resource • Alcoa in the aluminum market • DeBeers in Diamond market • Patents or Secret Formula: • Xerox: Controlled photocopying • Regulations: Jockey Club, SDTM • Gambling is a legally restricted monopoly • Returns to Scale: • TownGas is an regulated monopoly supplier of a particular type of piped natural gas (may have competition from LNG)

17. Monopolist with high fixed costs ATC D MC MR

18. Surplus • The demand curve represents how much consumers are willing to pay for one more unit of a good, if they have already bought a certain number of goods. • There are diminishing returns to any given product. As people consume more of that product, the benefit they get from consuming another one declines, and they are only willing to pay a lower price. • Difference between the price people are willing to pay for a good (i.e. the position of the price schedule) and the actual price is the consumer surplus (net benefit to the consumer) generated by that purchase.

19. 11 10 10 9 9 8 8 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 1 2 3 4 5 6 7 8 9 10 P Surplus generated by buying first good = 6 P = 3 Q

20. 11 10 10 9 9 8 8 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 1 2 3 4 5 6 7 8 9 10 P Surplus generated by buying second good = 5 P = 3 Q

21. 11 10 10 9 9 8 8 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 1 2 3 4 5 6 7 8 9 10 P Total consumer surplus is the sum of surplus of each good P = 3 Q

22. 11 10 9 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8 9 10 P When goods adjust continuously, total consumer surplus is a triangle created by price line and demand curve P Q

23. Producer Surplus • Producers achieve profits whenever they sell an extra goods at a price above the cost of producing the extra good. • Sum of profits for each good is the total producer surplus, the area in the triangle below the price line and above the supply curve.

24. Competitive Market Producer Surplus S P* D Q*

25. Competitive Equilibrium is Efficient • Economic efficiency means that there are no gains to be had at the level of society from additional trades. • If the price is higher or lower, the sum of the areas of the consumer & producer surplus triangles will be less than at the equilibrium price. • Economic efficiency does not guarantee that the split of the surplus will coincide with any notion of fairness.

26. Efficient Equilibrium Market Consumer Surplus S Producer Surplus P* D

27. Monopoly Price D S P* Ceiling Q*

28. Total Societal Surplus is lower under monopoly Consumer Surplus Deadweight Loss S Ceiling Producer Surplus D Q*

29. Price Discrimination • What if you don’t have to charge the same price to everyone? • If you have perfect knowledge of the valuation applied to your product by each customer, you might tailor your price for each one. • Since lowering your price for each customer doesn’t affect the price obtained from higher value customers, you gain by selling at a price above marginal cost.

30. 11 10 10 9 9 8 8 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 1 2 3 4 5 6 7 8 9 10 P Total profit earned by firm P1 P2 P3 P4 P5 MC = 3 P6 Q

31. 11 10 9 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8 9 10 P Perfect Price Discrimination will generate same output as perfect competion, but monopolist will take all surplus as profit. P Q

32. Consequences of Market Power • One clear consequence of the existence of market power is that prices are higher than marginal cost and output is smaller than perfect competition. • Additional consequences of the presence of market power may be: • Complacency by firms managers (i.e. standard corporate governance measures do not generate efficiency) • Rent-seeking: Firms may put effort into constructing artificial barriers to entry rather than producing goods.

33. Contestable Marketsand Strategies to Deter Entry • A monopoly firm may not set profit maximizing prices because they want to keep the price low enough to keep other firms out. • A market in which the possibility of market entry tempers the behaviors of monopolists is called a contestable market. • A pricing strategy to prevent entry is called limit pricing. • Firms may also use other strategies to deter entry which are less beneficial than lowering prices and increasing production.

34. Strategies of Entry Deterrence • A firm may deter entry by competitors by threatening them with : • Engaging in predatory pricing. • Price below marginal cost to drive another firm out of the market. • Building excess capacity (promise predatory pricing)

35. Oligopoly • Many industries are dominated by a small number of firms: Airlines, airplane manufacturing, supermarkets, drugstores. • In theory, even a small number of firms may compete, driving down prices to the level of costs. • Airplane manufacturing: Boeing vs. Airbus • Oligopolists may also collude! • OPEC • Sotheby’s and Christie’s

36. Conditions of Cartel • Small number of firms • Barriers to Entry • Ineffective or Non-existent government regulation. • Way to Stop Cheating • Enforcer • Capacity Constraints (California Electricity Market)

37. Duopolists • Two companies can agree on a price at which they could make profits. • If the other firm keeps its word, you can win whole market by undercutting their price. • If the other firm doesn’t keep its word, you must undercut the agreed upon price or lose everything. • Either way, best strategy is to cheat on agreement.

38. Payoff Matrix • Two firms • Each one could choose to collude and charge a price of 475. • Or each could decide to cheat, steal the market for themselves and charge a price of 450 • The matrix describes the payoff of each firm given the strategies of another.

39. Game Theory & Beautiful Mind • Game Theory is a branch of math that describes strategic interactions. • Nash describes a game that is in equilibrium as one in which no player has an incentive to change their strategy given the strategy of the other player. • Nash equilibrium in the above game is for both to cheat even though they both players would be better off if they could collude.

40. California, 2000 • In 1998, utilities in California’s deregulated wholesale power market were paying between $30 and $40 per MWH. By summer and fall of 2000, prices skyrocketed to $140. • Five firms producing wholesale electricity (Enron, Dynegy,…). When there is excess capacity, five firm market behaved relatively competitively. • When capacity constraints hit, firms could exercise significant pricing power and raise prices above marginal cost.

41. Sotheby’s and Christies Prior to 1995, Sotheby's and Christie's, the world's largest auction houses, were in fierce competition for consignments from sellers. ,… . In March 1995, this competition abruptly ended. Christie's … would charge sellers a fixed, non-negotiable commission … and a month later Sotheby's announced the same policies. Detailed documents kept by …, Christie's former chief executive, show that the abrupt change was due to a price-fixing conspiracy. Anatomy of the Rise and Fall of a Price-Fixing Conspiracy: Auctions at Sotheby's and Christie's Orley Ashenfelter and Kathryn Graddy * Why were these firms able to successfully form a cartel? Firms may compare future profits from staying in cartel relative to current profits from cheating. In lean markets, the benefits from cheating may be less than the future benefits from staying in a cartel.

42. Boeing vs. Airbus. • Why might it be difficult for two airlines to collude. • There is a large stock of existing aircraft available for sale in used market. • Durable goods producers have to compete with their own past. • Some economists claim that Alcoa did not have a monopoly because the broad supply of recycled Aluminum.

43. Natural Monopoly • In markets with a natural monopoly there may be one firm. • Economies of scale indicate that at marginal cost pricing firms make a loss. • Efficient production involves 1 firm. Firm will naturally charge markup and earn profits. • Government may step in, usually to put a maximum price level. Should be minimum amount necessary to get the firm to operate • Average cost pricing

44. Monopoly D ATC Average Cost Pricing MC MR Competition

45. Difficulty with Regulation • Competitive Markets are Self-Regulating. Many individual agents will be making small decisions that lead to a competitive outcome. • If single decision maker, information problems become acute. • East Tunnel – What is the proper return that a company should be entitled to. What is the true ATC. • How do you insure investment that will minimize ATC.

46. Does TownGas generate excessive profits? High operating profit to turnover ratio, but this may be a function of high capital costs. Return on Assets seems pretty good.

47. Monopolistic Competition • Most firms produce a good that is (to a certain extent) unique. No other good has the exact same properties. • Coke, Pepsi, President’s Choice • To the extent that you are a unique producer, you will have some market power. • Price elasticity of individual products are larger than total category. But not infinite as in the case of commodity goods.

48. Monopolistic Competition Short-Run D ATC MC MR

49. Characteristics of Monopolistically Competitive Markets • Differentiated Products • Free Entry into very similar markets. • Individual firms face downward sloping demand curve and a falling average total cost curve. • They would sell more if they could at the going rate but lowering their prices to sell more would lead to losses.

50. No Barriers to Entry • What happens if new firms can enter? • If there are profits to be had, entrepreneurs will enter markets to provide close substitutes for profit making goods. • New goods splitting the market and better substitutes means lower, flatter demand curve.