Once more: The ideal market ("Perfect competition")

Assumptions:

• Very large numbers of buyers and sellers: Nobody has a notable influence on supply, demand or price→ demand curve is horizontal (firms are 'price-takers': they can sell any quantity if only they accept the price)

• Homogeneous products• Free entry to and exit from markets• Everybody has adequate knowledge of prices and

technology• Technology is given exogenously

The other extreme: Perfect Monopoly

• A single firm (firm's demand = market demand)• Producing a unique product (no close substitutes)• Strong barriers to entry• Monopoly power allows to keep output low, raise

prices above competitive levels and make above-normal profits

Examples of (past) monopolies: network industries such as railways, electricity, gas, water or telecom

Monopoly: Marginal revenues decline much faster than prices, as the firm has to give each client the same price

50 1 2 3 4Quantity

10

5

8

3

1

Q P TR AR MR

0 10 0 - -

1 8 8 8 8

2 6 12 6 4

3 4 12 4 0

4 2 8 2 - 4

5 0 0 0 - 8

Q = QuantityP = PriceTR = Total RevenueAR = Average RevenueMR = Marginal Revenue

MR

D=AR=P

6

4

A monopolist maximizes profit, choosing Quantity Qm, where MC = MR (the golden rule of MC = MR still applies!)

0 Quantity

D = DemandP = PriceAR = Average RevenueMR = Marginal RevenueMC = Marginal costsAC= Average costs

ACMC

MR

D=AR=P

Monopoly profit

AC

Pm = AR

Qm

Deadweight loss through monopoly: It is not the fact that a monopolist produces less output; it is because the monopolist produces less consumer and less producer surplus!

Perfect competition and perfect monopoly are extreme forms and occur seldom in reality.

Intermediate forms of imperfect competition:

• Monopolistic competition

• Oligopoly (collusive or non-collusive oligopoly)

• Cartels

→One common thing under all forms of imperfect competition: There is some degree of market power = influence on price through a declining demand curve (to varying degrees)

Monopolistic competition:

• Large numbers of firms

• Free entry and exit

• Perfect knowledge

• Identical cost curves

• However, other than under perfect competition: "product differentiation" acts as a source of market power

Same as under perfect competition!

Some examples of "product differentiation"

• There is fierce competition among lots of music groups, but there is only one band called U2! This brand name (thanks to advertising, reputation etc.) gives some market power to U2

• Only Volkswagen can sell a "Golf", but lots of other producers offer cars in the "Golf class"

• There are lots of producers of sweet drinks, but only one can put the name "Coca Cola" on the bottle

• Among many restaurants, some succeed to establish a reputation for unique quality

→ All this leads to some price-setting power!

Market power:

• A perfect monopolist would typically have a steep (inelastic) demand curve as entry of competitors is blocked and there are no close substitutes

• Under monopolistic competition, the demand curve tends to be more elastic. Market power exists but is more limited, due to (close) substitutes: you could for example still choose Pepsi instead of Cola

• Under monopolistic competition, the elasticity of the demand curve (i.e. market power) depends on how unique the product can be made (in the perception of the clients)

• If uniqueness is small, monopolistic competition comes close to perfect competition

Oligopoly

• A few (often 2-3) dominant suppliers

• Often strong brand names (due to extensive advertising) act as an entry barrier to their market

• Oligopolists can produce homogeneous products (steel, paper, cement, aluminium) or differentiated products (Pampers, Guinness, Tempo)

• Oligopoly behaviour (price setting, choice of output) is hard to predict

An oligopoly as a prisoner's dilemma

A dominant strategy game: Profits (million Euro) for two firms (X and Y) at different prices

Firm X's price:

Firm Y's

price:

2 euro 1.80 euro

2 euro

A

Profit:

10 each

B

Profit:

5 for Y

12 for X

1.80 euro

C

Profit:

12 for Y

5 for X

D

Profit:

8 each

The kinked demand curve under oligopoly

Quantity

Pri

ce

D

Our price cuts will be followed by price cuts of our competitors and therefore we gain only

little extra sales

Our price increases will not be followed by our competitors and therefore we loose sales

D Typical for oligopoly: price

stability

Concern for anti-trust authorities:

• Strong interdependence: Each oligopolist's decision will affect the behaviour of the others. Oligopolists observe each other very carefully!

• Strategic behaviour: what are the most likely reactions of my rivals? How do they expect me to react to their actions?

• Collusion: Either explicit or "tacit" agreement to limit competition (e.g. set output quotas; fix prices; limit product promotion)

• Cartels: setting quotas, fixing prices• Price leadership: All other firms choose the same

price as the market leader (usually the largest firm)

Behind any imperfect market → Various types of barriers to entry (1):

• Economies of scale: If fixed costs take a high share of total costs (e.g. in network industries), one firm serving the whole market can produce at lowest costs! ("natural monopoly")

% of market share

Ave

rag

e t

ota

l co

sts

70%

If a firm has reached this position: how could a new entrant survive?

A "natural monopoly": Average total costs decline monotonically

30%

Behind any imperfect market → Various types of barriers to entry (2):

• Economies of scope: Producing a "family" of related products allows to make use of shared (overlapping) R&D, marketing, storage, transport facilities or advertising → synergies lead to cost-reduction

Example: • An automobile producer will typically offer a whole

range of cars and lorries; knowledge developed for one type of car can often be applied to others; the same holds for brand reputation, joint advertising, service networks etc.

Behind any imperfect market → Various types of barriers to entry (3):

• Product differentiation and brand loyalty: Strong association between a product / service and a brand.

Examples: • "let me xerox this paper …"• "let me google …"• "We pamper our clients …"

Behind any imperfect market → Various types of barriers to entry (4):

• Learning-by-doing: As a firm produces more of something, people become more efficient in handling machines, systems etc.

• Accumulated (tacit) knowledge: Personnel will accumulate ("tacit") knowledge from experience for improvements of products, services or procedures, will know the cheapest and most reliable suppliers, etc.

• Both points give a firm a first mover advantage!

Behind any imperfect market → Various types of barriers to entry (5):

• Ownership/control of key inputs or of distribution channels

Examples: A beer producer could deliver free equipment for a

bar if the bar exclusively sells his beer; Diamond producer De Beers controls a World wide

network for selling diamonds; Somebody happens to sit on an oil well.

Behind any imperfect market → Various types of barriers to entry (6):

• Legal protection: Patents, copyrights, trade marks, licences, or trade restrictions

• Mergers and takeovers: A monopolist could take over any new entrant.

Finally: Do firms really maximize profits?

Problems in real life:

• It is very hard to know exactly: What are the firm's costs? (see management accounting course later this year) and, even harder:

• What are the firm's demand curves? Determination of demand curves through statistical observation is very difficult!

Another problem: Principals versus agents

→Principals hire agents in order to serve the principals' interests, but the agents have their own interests …

Examples:

• Shareholders versus managers

• Supporting services in large conglomerates

• Suppliers and buyers of intermediate products

The principal-agent problem:

Painstaking questions by the principal: • Are my agents doing their best? • Are they producing at lowest possible costs? • Do they deliver the best possible quality?

General difficulty:• Agents may take advantage from the limited

observability of their work; they tend to know more about their work than do their principals; they can selectively inform the principals

Solution → Incentive contracts? (perverse effects!)

Problem: For the principals, it can be rational being badly informed – why?

• A manager works full-time in a company; her principals (shareholders) will dedicate much less time to the company → information asymmetry!

• Information asymmetry is worst if ownership is dispersed among many small shareholders: Their marginal revenues of control are small compared to their marginal costs!

• An improvement: large block-holders (e.g. rich families, pension funds, life insurance companies or the "house bank" in Japan and Germany): higher control efforts → benefits of control are higher if you hold large blocks of shares!

Under dispersed ownership, there is still one disciplining mechanism left: Bad management → stock market value down → greater threat of an unfriendly takeover (risky for managers!)

Why is there more chance of a take-over?Tobin's Q = A firm's stock market value, divided by the accounting value of a firm's assets: If Q is much smaller than 1, you are an interesting candidate for a take-over! (A take-over is cheaper than founding a firm)

Note: This works with long delays and after a long period of really bad management!

There is room left for management to pursue own interests:

Shareholders: Maximum

profit!

Managers: growth & prestige; high salaries; a large Royal Court of assisting personnel; luxurious business trips andoffice rooms; favourable contracts for my best friends; discretionary investments ...

Control ?

Are my marginal revenues of control worth my marginal

costs!?

These bastards do not know all I know!

Diffuse data on costs, demand,

etc. (can be manipulated

within certain limits)

Empirical evidence: Manager-controlled firms in US and UK are less profitable than family firms!

Baumol's model: Set output at MR=0!Note:

• A profit-maximizer sets output at MR=MC (leading to Qpm and

Ppm)

• The output maximizer arrives at Psrm and Qsrm

Growth maximization: At some point, stock market valuation will decline as you may push growth by selecting poorer investment projects … and by extensive advertising

What are the limits of striving for growth? You must keep your shareholders happy, otherwise they sell their shares

→ danger of take-over!

Sto

ck m

arke

t va

luat

ion

Firm growth

Sto

ck m

arke

t va

luat

ion

Staffing

Nonetheless, management has some freedom: there is only a weak correlation between growth of assets and profitability!