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Economics for Management

GSB728

Topic 4:

Firms and Competition

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Note: This lecture note was prepared based on the teaching material provided

by the publisher of the textbook Principles of Economics.

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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?

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The Degree of Competition

• Classifying markets accordingly to:

– Number of firms.

– Freedom of entry to industry.

– Nature of product.

– Nature of demand curve.

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• The basic market structures:– Perfect competition– Monopoly– Monopolistic competition– Oligopoly

• Structure Conduct Performance

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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.

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0

$

(b) Firm

Q (thousands)

0

(a) Industry

$

Q (millions)

S

D

AR D = AR = MR

Qe

PeAC

ACMCProfit

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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


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


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

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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


$

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


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.

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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.

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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.

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Q 0

MC

AC

Qm

MR

AR

AR

Total profit$


AC



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

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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.


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.

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Comparison of Industry Equilibrium Monopoly and Perfect Competition Differing MC curves (I)

Q 0 Q1

P1

MC monopoly

AR = D

$

MR monopoly


$

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)


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.

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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.

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$

Q 0 Qs

AR = D

MC

AC

Ps

ACs

Monopolistic CompetitionShort-Run Equilibrium of the Firm

Economic profit

MR


AR = D

MRQ 0 QL

PL

LRAC

LRMC

Monopolistic CompetitionLong-Run Equilibrium of the Firm

$


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).

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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


Oligopoly• Key features of oligopoly:

– Barriers to entry.

– Interdependence of the firms.

• Examples in Australia:

– Motor vehicle industry, banking industry, supermarket .

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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


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


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).

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• Tacit collusion:

– Dominant firm price leadership.

– Barometric firm price leadership.

– Other forms of tacit collusion:• Average cost pricing.• Price benchmark (reference price).

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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


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)


• 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.)

http://www.accc.gov.au/

• 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


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


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


$

QO

P1

Q1

Kinked Demand for an Oligopolistic Firm (I)

D market

Current price and quantitygive one point on demandcurve.


QO

P1

Q1

$

D market

aLowering price below marketequilibrium ‘a’ will causeother firms to follow thus reducing elasticity of demand.


Kinked Demand for an Oligopolistic Firm (II)

QO

P1

Q1

MC2

MC1

MR

a

bD = AR

Kinked Demand Curve Promotes Price Stability

$

E1


• 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.

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QO

10

D

200

Third-Degree Price Discrimination (I)$

Revenue from a singlePrice 200 x $10 = $2,000


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

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Third-Degree Price Discrimination (II)


• 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.

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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


• Price discrimination and the consumer:

– Not clear-cut decision can be made (some consumers might benefit while other might loose).

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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.

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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.

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