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Pure Competition and Monopolistic Competition Chapter 10

Pure Competition and Monopolistic Competition Chapter 10. Pure competition is a standard against which other market structures are compared. The product is perfectly undifferentiated .

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Pure Competition and Monopolistic Competition Chapter 10

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  1. Pure Competition and Monopolistic CompetitionChapter 10 • Pure competition is a standard against which other market structures are compared. The product is perfectly undifferentiated. • When there are many firms, but the product is differentiated, the market is monopolistically competitive. • This brand competition may involve advertising campaigns and large promotional expenditures to stress often minor distinctions among products 2005 South-Western Publishing

  2. Michael Porter’s Five Forces of Competitive Advantage The forces that determine competitive advantage are: • Substitutes (threat of substitutes can be offset by brands and special functions served by the product). • Potential Entrants (threat of entrants can be reduced by high fixed costs, scale economies, restriction of access to distribution channels, or product differentiation). • Buyer Power (threat of concentration of buyers). • Supplier Power (threats from concentrated suppliers of key inputs affect profitability). • Intensity of Rivalry (market concentration, price competition tactics, exit barriers, amount of fixed costs, and industry growth rates impact profitability).

  3. Figure 10.2 on Page 433 Potential entrants High capital requirements Economies of scale Absolute cost advantages High switching costs Lack of access to distribution channels Product differentiation Public policy constraints Substitutes Value-price gap Branded vs. generic Sustainable industry profitability Intensity of rivalry Industrial concentration Pricing tactics Switching costs Exit barriers Cost fixity Industrial growth rates Buyer power Buyer concentration Overcapacity Homogeneity of buyers Potential of integration Outside alternatives Supplier power Unique suppliers Number of suppliers Supply shortages or surplus Degree of vertical integration

  4. What Went Wrong With Xerox? • After inventing chemical paper copiers, Xerox enjoyed 15% growth rates in the 1960s and 70’s. • As their patents expired, new rivals such as Ricoh and Cannon aimed their copiers at smaller businesses and smaller volume users. • Xerox continued to build all parts in-house and suffered from serious price competition. Xerox’s strategy led to erosion of its once dominant status to that of an also-ran.

  5. Break-even Sales Change Analysis • The price-cost margin percentage (pCM) is defined as pCM = ( P – MC )/P. • A price cut may help or hurt profitability depending on price elasticities and price cost margins. • Ask how much quantity must output change after a price cut to breakeven (from before the price cut). • If we cut prices 10%, to breakeven the percentage change in quantity (DQ/Q) must be large enough to satisfy the equation to breakeven: pCM / (pCM% – .10) < (1 + DQ/Q ) • The larger is the price-cost margin percentage, the smaller will be the necessary quantity response to justify cutting price. • If pCM is 80%, then .8/(.8-.1) = 1.14. Hence, a 10% cut in price must be offset by at least a 14% increase in quantity to breakeven. • If pCM is only 20%, then .2/(.2-.1) = 2. Hence, a 10% cut in price must be offset by at least a 20% increase in quantity to breakeven.

  6. The Relevant Market Concept • A market is a group of economic agents that interact in a buyer-seller relationship. The number and size of the buyers and sellers affect the nature of that relationship. • A popular measure of concentration is the percentage of an industry comprised of the top 4 firms. Similarly, the market share held by the top 4 buyers is a popular measure of buyer concentration. • The relationship among firms is affected by: a. the number of firms and their relative sizes. b. whether the product is differentiated or standardized. c. whether decisions by firms are independent or coordinated (collusion).

  7. A Continuum of Market Structures:Competition Pure Competition assumes: 1. a very large number of buyers and sellers 2. homogeneous product (standardized) 3. complete knowledge of all relevant market information 4. free entry and exit (no barriers) These assumptions imply several things about competitive markets, including price equals marginal cost.

  8. A Continuum of Market Structures:Monopoly Monopoly assumes: 1. Only one firm in the market area 2. Low cross price elasticity with other products. 3. No interdependence with other competitors. 4. Substantial entry barriers These assumptions imply several things about monopolies, including that the monopoly price is well above marginal cost. Monopoly is discussed in full in Chapter 11.

  9. A Continuum of Market Structures:Monopolistic Competition Monopolistic competition assumes: 1. A large number of firms, some of which may be dominant in size 2. Differentiated products 3. Independent decision making by individual firms 4. Easy entry and exit These assumptions imply several things about monopolistic competition, including that the price in the long run is equal to average cost.

  10. A Continuum of Market Structures:Oligopoly Oligopoly assumes: 1. Only a few firms in the market area 2. Products may be differentiated or undifferentiated 3. There is a large degree of interdependence with other competitors These assumptions imply several things about monopolies, including that the monopoly price is well above marginal cost. Chapter 12 discusses oligopoly markets.

  11. Price-Output Determination Under Pure Competition Competitive firms attempt to maximize profits. Competitive firms cannot charge more than the market price of others, since their product is identical to all others. Hence, competitive firms are price takers. Total revenue, TR, is P·Q, where price is given. Therefore, marginal revenue, MR, is price, P. Profit is total revenue minus total cost  = TR - TC).

  12. Profit maximization implies that each firm produces an output where Price = Marginal Cost (P = MC). • To produce more than this quantity implies that P < MC, which is not the most profitable decision. • To produce less than where P=MC, implies that P > MC, and the firm could increase profits by expanding output. • In short run, a competitive firm may earn economic profits. • In long run, entry pushes price down to the minimum point of the average cost curve, so that economic profits are zero.

  13. Equilibrium Price in a Competitive Market • Equilibrium for each firm if P = MC. Each firm is “happy” • Equilibrium for the industry if: Demand equals Supply at the going price • When both occur, the market is in a Competitive Equilibrium MC MC AC D a firmthe industry CAN EARN ECON PROFITS IN THE SHORT RUN

  14. A Competitive Equilibrium Implies: 1. Competitive firm can earn positive economic profits in the SR 2.If Price < AVC, firm will shut down so-called “shut down price” is lowest AVC 3.In LR, entry forces price down to the minimum of the AC curve MC AC Pmin AC shut down price AVC

  15. PROBLEM: The following is given: For the industry: QS = 3000 + 200 P and QD = 13500 - 500 P For the firm: FC = 50 MC = 3 Q FIND OPTIMAL output for this firm.

  16. Answer: Find equilibrium price. Set D = S we see 3,000 + 200 P = 13,500 - 500 P. This implies: 10,500 / 700 = P = $15. At this price, the firm produces where P = MC, so 15 =3 Q Q = 5

  17. Monopolistic Competition • Monopolistic Competition • MARKET STRUCTURE • Many Firms and Many Buyers • Easy Entry & Exit • PRODUCT DIFFERENTIATION ! ! ! • Historical Background • Joan Robinson “Economics of Imperfect Competition,” 1933 • Edward Chamberlin, “Theory of Monopolistic Competition, 1933 • Small Groups & Large Groups Product Differentiation Among Gas Stations

  18. Product Differentiation • Differentiationoccurs when consumers perceive that a product differs from its competition on any physical or nonphysical characteristic, including price. • Examples: restaurants, dealer-owned gas stations, Video rental stores, book & convenience stores, etc. • Assumptions of the Model: • Large number of firms • Differentiated Product • Conditions of Cost and Demand are Similar • Easy Entry & Exit

  19. In the Short Run produce where MR= MC price on the demand curve NOTICE: P > MC economic profits exist P > AC there exists incentives for entry into this industry Basic Model of Monopolistic Competition MC AC PM D QM SHORT RUN DIAGRAM MR

  20. Entry in this industry “steals” customers. Demand curve shifts inward RESULTS MR = MC (like monopoly) P = AC (like competition) Profits in LR are zero (like competition) not at Least Cost Point of AC curve (like monopoly) Profits in the SR Induces Entry MC AC P D D’ Q MR LONG RUN DIAGRAM

  21. Inefficient Production EXCESS CAPACITY not at least cost point of AC curve Could Avoid Excess Capacity by JOINTLY PRODUCING at the same plant Kroger Salt & Morton Salt at same plant Sears’ Kenmore and Whirlpool built at same factory. Does the expectation of zero profits in the future stifle innovation? Is there too much product differentiation? Properties of Monopolistic Competition

  22. Selling and Promotional Expenses • Suppose that the price is determined outside of the model, as with liquor prices in some States. • We will expand promotional activities until the extra profit associated with the activity equals the extra cost of the promotion. • This decision rule for Optimal Advertising is when: Contribution Margin = Marginal Cost of Advertising or P – MC = k • DA/DQ • or expand advertising whenever (P – MC)( DQ/DA) > k • where, contribution (P – MC) is the marginal profit contribution of an additional sale, and the marginal cost of advertising is ( k •DA/DQ).

  23. Example • To sell one more unit of output will cost the price of the added message, k, divided by the marginal product of a dollar of advertising (DQ/DA). • If a radio message costs $1000, and if that message yields 5 new items sold, then the marginal cost of advertising is $200, ($1000 /marginal product of advertising). • If it costs $200 to sell one more car (MCA=$200), and if the contribution of another car sold is $300 to profits, then we should expand promotional expenses.

  24. What Went Wrong With Amazon.com • Stocks only 1,000 books but displays 2.5 million • Barnes & Noble and Borders are profitable, but Amazon didn’t earn a profit • Classic example of a business with low barriers to entry • Internet buyers are very price conscience, as they can shop multiple sites with MySimon.com and others

  25. Competitive Markets Under Asymmetric Information • Used car: who knows what about it? • Asymmetric Information-- unequal or dissimilar knowledge among market participants. • Incomplete Information -- uncertain knowledge of payoffs, choices, or types of opponents a market player faces.

  26. Search Goods versus Experience Goods • Search goodsare products or services whose quality is best detected through a market search. • Experience goodsare products and services whose quality is undetected when purchased. • Warranties and firm reputations are used to assure quality. • But if someone is selling his or her car, isn't it likely that the car is no good? Is ita lemon? • This is an explanation why used car prices are so much lower than new car prices. • If one firm defrauds customers, how do the reputable firms signal that they are NOT like the fraudulent firm?

  27. Adverse Selection and the Notorious Firm • Suppose that a firm may decide to produce a High QualityorLow Qualityproduct, and the buyer may decide to offer a High Price or a Low Price. • Since the firm fears that if it offers a High Quality product but that buyers only offer a Low Price, they only produce Low Quality products and receive Low Prices. • This is the problem of adverse selection

  28. Payoffs in the boxes are for the seller only Notorious Firm Analysis BUYER • Simultaneous decisions of buyer & seller • A risk averse decision by the firm is to make a Low Quality product • Best for the buyer is a low price, but a high quality good. Worst for the buyer is a high price but a low quality good. Hi Price Low Price High Quality Low Quality 130 70 150 90 SELLER We end in a trap of only poor quality goods at low prices.

  29. Solutions to the Problem of Adverse Selection • Regulation(Disclosure Laws, Truth in Lending) • Long term relationships, or reliance relationships • Brand names (a form of a “hostage” to quality) • Nonredeployable assets are assets that have little value in another other use • Example: Dixie Cups made with paper-cup machinery which cannot be used for other purposes — if Dixie Cups leak, the company is in trouble

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