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Economics for Management
GSB728
Topic 4:
Firms and Competition
1
Note: This lecture note was prepared based on the teaching material provided
by the publisher of the textbook Principles of Economics.
2
Learning Objectives
1. The degree of competition - How much competition does a firm face?
2. Perfect competition – What happens when there are very many firms all competing against each other? Is this good for us as consumers?
3. Monopoly – What happens when there is only one firm in the market? Do we as consumers suffer?
4. Monopolistic competition - Assumptions. 3
Learning Objectives (contd.)
5. Oligopoly - What happens if there are just a few firms that dominate the market? Will they compete or get together?
6. Price discrimination - In what situations will firms be able to charge different prices to different consumers? How will we or consumers benefit or lose from the process?
4
The Degree of Competition
• Classifying markets accordingly to:
– Number of firms.
– Freedom of entry to industry.
– Nature of product.
– Nature of demand curve.
5
• The basic market structures:– Perfect competition– Monopoly– Monopolistic competition– Oligopoly
• Structure Conduct Performance
6
The Degree of Competition (contd.)
Four Market Structures
7Source: Sloman et al. (2014).
Market Structures and Product Differentiation
8Source: Krugman & Wells (2013).
Perfect Competition• Assumptions:
– Firms are price takers.
– Freedom of entry.
– Identical product.
– Perfect knowledge of the market.
• Short-run equilibrium of the firm:
– Price, output and profit.
9
0
$
(b) Firm
Q (thousands)
0
(a) Industry
$
Q (millions)
S
D
AR D = AR = MR
Qe
PeAC
ACMCProfit
10
Derivation of Short-Run Profit Under Conditions of Perfect Competition
Source: Sloman et al. (2014).
0
$
(b) Firm
Q (thousands)
0
(a) Industry
$
Q (millions)
S
D
AR D = AR = MR
Qe
Derivation of Short-Run Loss Under Conditions of Perfect Competition
PeAC
AC
MCloss
11Source: Sloman et al. (2014).
O O
(a) Industry
$
Q (millions)
S
(b) Firm
D1 = MR1
MC
D2 = MR2
D3 = MR3
Q (thousands)
ab
c
= S
Derivation of the Short-Run Supply Curve
D1
D2 D3
P1
P2
P3
P
12Source: Sloman et al. (2014).
Perfect Competition: Long Run Equilibrium
• Long-run equilibrium of the firm:
– Supernormal profits eventually eliminated through competition as new firms enter the market.
– LRAC = (SR)AC = MC = MR = AR
13
0 0
(a) Industry
$
Q (millions)
S1
D
(b) Firm
LRAC
QL
Se
ARL DL
Q (thousands)
Long-Run EquilibriumUnder Perfect Competition
New firms enter andsupply moves to the rightS1 to Se
At P1(=AR1 = D1) supernormalprofits (P1 > LRAC) but entry of new firms forces price downto PL(=ARL= DL) and Supernormal profits are eventually eliminated.
P
P1
PL
P1 D1
14Source: Sloman et al. (2014).
$
Q 0
(SR) AC (SR)MC
LRAC
D = AR = MR
Equilibrium = LRAC = (SR)AC =(SR)MC = MR =AR
Perfect CompetitionLong-Run Equilibrium of the Firm
15Source: Sloman et al. (2014).
Growth of an Industry After a Shift in Demand
16Source: Taylor and Frost (2009).
Perfect Competition (contd.)• Incompatibility of perfect competition and substantial
economies of scale: When firms expand to achieve economies of scale they usually gain market power (undercut prices to decrease competition).
• Is perfect competition good for consumers?
– Price equals marginal cost (efficient).
– Prices kept low (firms operate at minimum LRAC).
– Firms must be efficient to survive.
17
Monopoly• Monopoly exists when: 1) there is only one firm in
the industry 2) selling a particular product and 3) there are barriers to entry.
• Barriers to entry:– Economies of scale.– Product differentiation and brand loyalty.– Lower costs for an established firm.– Ownership/control of key production factors.– Ownership/control over inputs or outlets.– Legal protection.– Mergers and takeovers.– Aggressive tactics. 18
Monopoly (contd.)• The monopolist’s demand curve is:
– Downward sloping.
– MR falls below AR.
• Equilibrium price and output:
– Equilibrium output achieved where MC = MR.
– Equilibrium price given by the demand curve.
19
Q 0
MC
Qm
MR
AR
P = AR
$
Profit Maximisation Under Monopoly
Source: Sloman et al. (2014). 20
Monopoly (contd.)
• Profit:
– Supernormal profit can persist in long run.
21
Q 0
MC
AC
Qm
MR
AR
AR
Total profit$
Profit Maximisation Under Monopoly
AC
Source: Sloman et al. (2014). 22
Profit Maximisation Under Monopoly
23Source: Pindyck & Rubinfeld (2013).
Monopoly (contd.)
• Monopoly versus perfect competition: which best serves the public interest?
– Short-run price and output• Monopoly: high prices/low output: short run
– Long-run price and output• Monopoly: high prices/low output: long run
24
O
MC ( = supply under perfect competition)
Q1
P1
Q2
AR = D
Q
$
Comparison of Industry Equilibrium: Monopoly and Perfect Competition Assuming same MC curve
P2
AR=D=MR under perfect competition.
Equilibrium under perfect competitiongives lower price
and increased output.
MR monopoly
Monopoly equilibriumrestricts output andmaximises price.
Source: Sloman et al. (2014). 25
Monopoly (contd.)
• Monopoly versus perfect competition: which best serves the public interest?– Costs under monopoly:
• Costs may be higher - barriers to entry.
• Costs may be lower - economies of scale.
– Super-normal profit for research and development and investment.
– Competition for corporate control.
– Innovation and new products.
26
Comparison of Industry Equilibrium Monopoly and Perfect Competition Differing MC curves (I)
Q 0 Q1
P1
MC monopoly
AR = D
$
MR monopoly
Source: Sloman et al. (2014). 27
$
0
MC perfect competition ( = supply)
Q1
P1
P2
Q2
MC monopoly
AR = D
Q3
P3
Q
MC monopoly
MC perfect competition ( = supply)
=MR perfect competition
MR monopoly
Q4
Comparison of Industry Equilibrium Monopoly and Perfect Competition Differing MC curves (II)
Source: Sloman et al. (2014). 28
Q1 Produced
Q3 Produced
Theory of Contestable Markets
• A perfectly contestable market has three main features:
– No entry or exit barriers.
– No sunk costs (costs that cannot be recouped).
– Access to the same level of technology.
29
Theory of Contestable Markets (contd.)
• Theory of contestable markets:
– Relevance of potential competition (threat of competition).
– How contestable is the market? (is there free and costless entry and exit).
– Contestable markets and natural monopolies (economies of scales and size of the market affect contestability of markets).
– Importance of costless exit (absence of sunk costs, which cannot be recouped).
• Contestability and the consumer’s interest.30
Monopolistic Competition
• Assumptions of monopolistic competition:• Large number of firms.
• Interdependence.
• Freedom of entry.
• Product differentiation.
– Examples in Australia:• Petrol stations, hairdressers, restaurants, breakfast
cereals, soft drinks, etc.
31
$
Q 0 Qs
AR = D
MC
AC
Ps
ACs
Monopolistic CompetitionShort-Run Equilibrium of the Firm
Economic profit
MR
32Source: Sloman et al. (2014).
AR = D
MRQ 0 QL
PL
LRAC
LRMC
Monopolistic CompetitionLong-Run Equilibrium of the Firm
$
Source: Sloman et al. (2014). 33
Monopolistic Competition• Non-price competition:
• Product development/differentiation.• Advertising.
• The public interest:– Comparison with perfect competition:
• Less will be sold and at a higher price.• Firms will not be producing at the least-cost point
(due to excess of capacity).• Difference in price expected to be small.• Variety of products to choose from.
– Comparison with monopoly:• More will be sold at lower prices (more competition).
34
Q2 Q0
P1
LRAC
DL monopolistic competition
Q1
Perfect and Monopolistic CompetitionLong-Run Equilibrium of the Firm Contrasted
$
P2
DL perfect competition
Long-run equilibrium under perfect competition
Long-run equilibrium under monopolistic
competition
Source: Sloman et al. (2014). 35
Oligopoly• Key features of oligopoly:
– Barriers to entry.
– Interdependence of the firms.
• Examples in Australia:
– Motor vehicle industry, banking industry, supermarket .
36
Is the Australian’s Banking Sector Under Oligopoly? Banks’ % Share of Total Bank Assets
Bank %Commonwealth 18.6National Australia 18.2Westpac 15.2ANZ 14.6
Sub-total – four largest banks 66.7All other banks 33.3Total – all banks 100.0
37Source: Sloman et al. (2014).
Oligopoly (contd.)• Decision: Competition or collusion.
• Non-Collusive oligopoly: Oligopolists have no agreement between themselves, formal, informal or tacit.
• Collusive oligopoly: Oligopolists agree formally or informally to limit competition between them.
– They must set quotas, fix prices, limit product promotion or development, or agree to respect each other’s market share.
– Cartel: Formal collusive agreement.38
Q 0 Q1
P1
$
Profit-Maximising Oligopolistic Cartel
D industry = AR industry
MC industry
MR industry
Source: Sloman et al. (2014). 39
Oligopoly (contd.)• Cartels:
– Equilibrium of the industry: Similar to monopoly. Quantity will be reduced to increase prices and profits of members of the cartel. How?
– Allocating and enforcing quotas (production or sell quota set by a cartel): Output that each member of a cartel is allowed to produce or sell.
– Example: The Organisation of Petroleum Exporting Countries (OPEC).
40
• Tacit collusion:
– Dominant firm price leadership.
– Barometric firm price leadership.
– Other forms of tacit collusion:• Average cost pricing.• Price benchmark (reference price).
41
Oligopoly (contd.)
Q 0
Oligopolistic Price Leader Aims to Maximise Profits for a Given Market Share (I)
$
D market = AR market
D leader = AR leader
PL
Q L
MC leader
MR leader
Q M
EL EM
Price leader has majormarket share andsets market price
Market follows price
leader
Source: Sloman et al. (2014). 42
Q 0
$
D market = AR market
D leader = AR leader
Q L
MC leader
MR leader
Q M
EL EMPL (=M)
PL1
Q L1
EL1
Leader drops price
Market may retaliate -price war!
Leader increases market share
Oligopolistic Price Leader Aims to Maximise Profits for a Given Market Share (II)
Source: Sloman et al. (2014). 43
• Factors favouring collusion:– Few firms.
– Open with each other about costs and production methods.
– Similar production methods and average costs.
– Similar products.
– There is a dominant firm.
– Significant entry barriers.
– The market is stable.
– No government measures to stop collusion (Antitrust laws in US, Europe and Australia’s Competition and Consumer Commission – ACCC: http://www.accc.gov.au/). 44
Oligopoly (contd.)
• Non-collusive oligopoly: firms decide do not cooperate.
• Game theory– Alternative strategies including:
• Maximin (choosing the strategy whose worst possible outcome is the least bad) and Maximax (choosing the strategy that has the best possible outcome).
– Simple dominant strategy games:• The prisoners’ dilemma.
• Nash equilibrium (position resulting from everyone making their optimal assumptions about their rival’s decisions).
– The importance of threats and promises.– The importance of timing of decisions.
• Decision trees/First mover advantage/disadvantage. 45
Oligopoly (contd.)
$2.00 $1.80
$2.00
$1.80
X’s price
Y’s price
A B
C D
$10m each
$8m each$12m for Y$5m for X
$5m for Y$12m for X
Game theory:Profits for Firms X and Y at Different Prices
46Source: Sloman et al. (2014).
Not confess Confess
Notconfess
Confess
Sue's alternatives
Bill'salternatives
A B
C D
Each gets1 year
Each gets3 years
Bill gets3 monthsSue gets10 years
Bill gets10 yearsSue gets3 months
The Prisoners’ Dilemma
47Source: Sloman et al. (2014).
Boeingdecides
500 seater
500 seater
500 seater
400 seater
400 seater
400 seater
Boeing –$10mAirbus –$10m (1)
Boeing +$30mAirbus +$50m (2)
Boeing +$50mAirbus +$30m (3)
Boeing –$10mAirbus –$10m (4)
Airbusdecides
B2
Airbusdecides
B1
A
Decision Tree
or
or
or
48Source: Sloman et al. (2014).
$
QO
P1
Q1
Kinked Demand for an Oligopolistic Firm (I)
D market
Current price and quantitygive one point on demandcurve.
Source: Sloman et al. (2014). 49
QO
P1
Q1
$
D market
aLowering price below marketequilibrium ‘a’ will causeother firms to follow thus reducing elasticity of demand.
Source: Sloman et al. (2014). 50
Kinked Demand for an Oligopolistic Firm (II)
QO
P1
Q1
MC2
MC1
MR
a
bD = AR
Kinked Demand Curve Promotes Price Stability
$
E1
Source: Sloman et al. (2014). 51
• Oligopoly and the consumer:
– Collusion is negative for consumers. Some disadvantages like less scope for economies for economies of scale.
– Some advantages are:• Oligopolists could use part of their abnormal profits
for research and product development/Non-price competition. Also price stability.
– Countervailing power (market power of a seller is offset by powerful buyers who can prevent the price to raise.
– Difficult to draw general conclusions. 52
Oligopoly (contd.)
Price Discrimination• Price discrimination: A firm sells the same product
at different prices.
– First degree
• Approximate examples in Australia could include bargaining at market stalls, and some services.
– Second degree• Examples in Australia include water, electricity,
bulk buying.
– Third degree (the most common form)• Examples in Australia include cinema tickets, airline
tickets, rail and bus tickets.53
Price Discrimination (contd.)
• Conditions necessary for price discrimination:
• Firms must be able to determine own price (not price takers).
• Separate markets (not possibility of resell or arbitrage).
• Differing demand elasticities between markets.
54
QO
10
D
200
Third-Degree Price Discrimination (I)$
Revenue from a singlePrice 200 x $10 = $2,000
Source: Sloman et al. (2014). 55
O
D
200 Q
$
10
20
A high discriminatory price of $20 is now introduced atwhich 150 units are sold, givingrevenue of 150 x $20 = $3, 000
With price discrimination,total revenue is increasedfrom $2,000 to $3,500
Revenue from previousprice now (200-150) x 10= $500
150
Third-Degree Price Discrimination (II)
Source: Sloman et al. (2014). 56
• Advantages of Price discrimination to the firm:
• Higher revenue.
• Used to drive competitors out of business in specific markets.
• Used to subsidise predatory pricing (selling at a price below average variable cost in order to drive competitors out of the market) in a particular market.
57
Price Discrimination (contd.)
0 00
MRX
(a) Market X (b) Market Y
DX
Profit-Maximising Output UnderThird-Degree Price Discrimination
(c) Markets X + Y
MRT
5
1,000
$
DY
MRY
2,000
97
MCT
3,000
MCX
MCY
Total revenue withprice discrimination
= $23,000
TR = $9 x 1,000 = $9,000 TR = $7 x 2,000 = $14,000
58Source: Sloman et al. (2014).
• Price discrimination and the consumer:
– Not clear-cut decision can be made (some consumers might benefit while other might loose).
59
Price Discrimination (contd.)
References
Krugman, P. and Wells, R. (2013). Economics (3rd ed.). New York: Worth Publishers.
Morales, L. E., Simons, P. and Valle de Souza, S. (2014). GSB728: Economics for Management [Topic Notes]. Armidale, Australia: University of New England, Graduate School of Business.
Pindyck, R. and Rubinfeld, D. (2013). Microeconomics (8th ed.). New Jersey: Pearson.
60
References (contd.)
Sloman, J., Norris, K and Garratt, D. (2014). Principles of Economics (4th ed.). French Forest, Australia: Pearson.
Taylor, J. and Frost, L. (2009). Microeconomics (4th ed.). Milton, Australia: John Wiley & Sons.
61