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Pricing in Various Market Structures

Pricing in Various Market Structures. By Gavin C Reid Professor of Economics, School of Economics & Finance, University of St Andrews Director, Centre for Research into Industry, Enterprise, Finance and the Firm (CRIEFF) Presentation to the Competition Appeal Tribunal, London, 6 June 2013.

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Pricing in Various Market Structures

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  1. Pricing in Various Market Structures By Gavin C Reid Professor of Economics, School of Economics & Finance, University of St Andrews Director, Centre for Research into Industry, Enterprise, Finance and the Firm (CRIEFF) Presentation to the Competition Appeal Tribunal, London, 6 June 2013

  2. Outline Basic models Standards by which to judge economic efficiency Collusive and non-collusive oligopoly Two models of oligopoly: partial monopoly/price leadership; kinked demand curve. Modern developments: Kinked demand curves and Edgeworth cycles

  3. Basic Models • Perfect competition [see Knight (1921), Makowsky and Ostroy(2001)] - large numbers of rivals, unimpeded entry and exit, with a homogenous product, and given technologies. • Monopoly, Marshall (1890), – sole production of a homogeneous product, with a fully balkanised market. • Oligopoly – ‘competition among the few’, Fellner (1949), in which each firm is in significant strategic interaction, and rivalry is limited.

  4. Anti-competitive agreements Examples of agreements which can be anti-competitive include, according to Gov.UK, the following: • price-fixing (agreeing with any other business on a minimum price at which to sell goods or services) • limiting production to drive up prices • if 2 contracts are put out to tender, agreeing with your competitor to only bid on 1 each • agreeing not to sell to a competitor’s customers or compete against them in a certain area • If 2 or more competitors make agreements like these, it might constitute a ‘cartel’.

  5. Perfect Competition Provides a yardstick against which to judge other forms of competition Is in itself a fundamental component of the economist’s analysis of efficiency Efficiency so conceived is thought of in terms of Pareto (i.e. a Pareto efficient change makes at least one economic agent better off without making any one worse off) One element of Pareto efficiency, as applied to the firm, is that price is set equal to marginal cost.

  6. Degree of Monopoly A commonly adopted measure of degree of monopoly it the Lerner (1934) index: L = (Price – Marginal cost)/ Price; or L=(P-MC)/P It is zero if marginal cost pricing is used i.e. P = MC

  7. Measuring Monopoly Distortion Consumers’ and Producers’ Surplus are common devices for calibrating the efficiency losses due to monopolisation. A perfectly competitive market maximizes the sum of consumers’ and producers’ surplus. Monopolisation gives rise to a measurable ‘deadweight loss’ of consumers’ and producers’ surplus.

  8. Variants of Basic Models Monopolistic Competition (Chamberlin, Robinson, 1933) - many rivals, mild product differentiation, easy entry and exit, social optimality or sub-optimality? Monopoly – partial, Nichol (1930), multiple plant, price discriminating, natural [e.g. Marshall (1890), Panzar and Rosse (1987)] Oligopoly (homogeneous, heterogeneous), collusive, non-collusive [e.g. Cournot (1838), Bertrand (1883)]

  9. Collusive Oligopoly Cartels – wide variety of forms, including: • joint profit maximization • market sharing (e.g. non-price competition, market quotas) • price leadership (e.g. low cost, dominant firm, barometric firm) • partial monopoly [e.g. Forchheimer (1908), Reid (1977)] • basing point

  10. K-firm Cartel Equilibrium £ per unit £ per unit S p* set by cartel (dominant firm, price leader) p* accepted by fringe MCk P* D MR O xk O x xf + xk x xf

  11. Non-Collusive Oligopoly Non-collusive oligopoly analysis includes: Cournot(1838), Edgeworth, Bertrand (1883), Stackelberg (1952) leader-follower, Chamberlin (1933) small group, Hall-Hitch-Sweezy (1939) kinked demand curve, Maskin and Tirole (1988)

  12. Kinked Demand Curve • This is a flexible model of heterogenous oligopoly that seems to capture many aspects of real life oligopolies. • There is a kink in the demand curve at the prevailing price, and above this kink the demand curve is highly elastic, and below it less elastic. • The equilibrium price is stable under both cost and demand variation. • The pricing behaviour is often consistent with high price-cost margins.

  13. Kinked demand and Edgeworth cycles Maskin and Tirole (1988) provide a game- theoretic account of both the kinked demand curve, and the Edgeworthcycle. They find: • Firms alternately choose their price • A special equilibrium type (MPE) which depends only on the rival’s price • Show that a kinked demand curve at the monopoly price is ‘renegotiation proof’

  14. Edgeworth Cycle • A war of attrition occurs, in which each firm waits for its rival to increase its price (a relenting strategy) • Relenting is a ‘public good’, but each firm wants its rival to increase the price, so they can undercut it. • A mixed strategy emerges with each firm relenting with a probability less than one, to avoid free-riding

  15. Conclusion • Common movement of prices across rivals (either up or down) is no necessary indication of collusion, price fixing, inefficiency or welfare loss: you need to know something about the market structure. • Judgment must be exercised as to whether pricing is collusive.

  16. General References Hal R Varian (2010) Intermediate microeconomics: a modern approach (2010), 8th edition, Prentice Hall. Oz Shy (1996) Industrial Organization: theory and applications, MIT Press, (especially Ch. 8). Geoffrey A. Jehle and Philip J. Reny(2011) Advanced Microeconomic Theory, 3rd Edition, Prentice Hall (2011).

  17. Specialised References Makowsky, L. and J. L. Ostroy (2001), Perfect competition and the creativity of the market, Journal of Economic Literature, 39, 479-535. Maskin, E. and J. Tirole (1988) A theory of dynamic oligopoly II: price competition, kinked demand curves, and Edgeworth cycles, Econometrica, 56(3), 571-599. Noel, M. (2007) Edgeworthprice cycles, cost-based pricing and sticky pricing in gasoline retail markets, Review of Economics and Statistics, 89, 324-334.

  18. Further References Bhaskar, V., S.Machin and G.C. Reid (1991) Testing a model of the kinked demand curve, Journal of Industrial Economics, 34, 241-254. Reid, G. C. (1977), Comparative statics of the partial monopoly model, Scottish Journal of Political Economy, 24(2), 153-162. Reid, G.C. (1981), The Kinked Demand curve Analysis of Oligopoly: theory and evidence, Edinburgh University Press.

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