(13) The Firm and Market Structure

Question 1

LOS 15. A: Describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Define perfect competition.

Answer 1

Perfect competition is a market structure in which the following five criteria are met: 1) All firms sell an identical product; 2) All firms are price takers - they cannot control the market price of their product; 3) All firms have a relatively small market share; 4) Buyers have complete information about the product being sold and the prices charged by each firm; and 5) The industry is characterized by freedom of entry and exit. Perfect competition is sometimes referred to as “pure competition”.

Firms face perfectly elastic (horizontal) demand curves at the price determined in the market because no firm is large enough to affect the market price.

Question 2

LOS 15. A: Describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Define monopolistic competition

Answer 2

Characterizes an industry in which many firms offer products or services that are similar, but not perfect substitutes. Barriers to entry and exit in the industry are low, and the decisions of any one firm do not directly affect those of its competitors. All firms have the same, relatively low degree of market power; they are all price makers. In the long run, demand is highly elastic, meaning that it is sensitive to price changes. In the short run, economic profit is positive, but it approaches zero in the long run. Firms in monopolistic competition tend to advertise heavily.

The demand curve faced by each firm is downward sloping; while demand is elastic, it is not perfectly elastic.

Question 3

LOS 15. A: Describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Define oligopoly market.

Answer 3

Oligopoly is a market structure in which a small number of firms has the large majority of market share. An oligopoly is similar to a monopoly, except that rather than one firm, two or more firms dominate the market. There is no precise upper limit to the number of firms in an oligopoly, but the number must be low enough that the actions of one firm significantly impact and influence the others.

While products are typically good substitutes for each other, they may be either quite similar or differentiated through features, branding, marketing, and quality. Barriers to entry are high, often because economies of scale in production or marketing lead to very larger firms. Demand can be more or less elastic than for firms in a monopolistic competition.

Question 4

LOS 15. A: Describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Define monopoly.

Answer 4

A monopoly market is characterized by a single seller of a product with no close substitutes. This fact alone means that the firm faces a downward-sloping demand curve (the market demand curve) and has the power to choose the price at which it sells its product. High barriers to entry protect a monopoly producer form competition. One source of monopoly power is the protection offered by copyrights and patents. Another possible source of monopoly power is control over a resource specifically needed to produce the product. Most frequently, monopoly power is supported by government.

Question 5

LOS 15. A: Describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Define natural monopoly.

Answer 5

A natural monopoly refers to a situation where the average cost of production is falling over the relevant range of consumer demand. In this case, having two (or more) producers would result in a significantly higher cost of production and be detrimental to consumers. Examples of natural monopolies include the electric power and distribution business and other public utilities. When privately owned companies ware grated such monopoly power, the price they charge is often regulated by government as well.

Question 6

LOS 15. A: Describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Sometimes, market power is the result of what?

Answer 6

compete with a company once it has reached a critical level of market penetration. eBay gained such a large share of the online auction market that its information on buyers and sellers and the number of buyers who visit eBay essentially precluded others from establishing competing businesses. While it may have competition to some degree, its market share is such that it has negatively sloped demand and a good deal of pricing power. Sometimes we refer to such companies as having a moat around them that protects them from competition. It is best to remember, however, that changes in technology and consumer tastes can, and usually do, reduce market power over time. Polaroid had a monopoly on instant photos for years, but the introduction of digital photography forced the firm into bankruptcy in 2001.

Question 7

LOS 15. A: Describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly. Fill in the blanks.

Answer 7

Question 8

LOS 15. b: Explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure. Define marginal revenue.

Answer 8

Marginal revenue is the increase in revenue that results from the sale of one additional unit of output. While marginal revenue can remain constant over a certain level of output, it follows the law of diminishing returns and will eventually slow down, as the output level increases. Perfectly competitive firms continue producing output until marginal revenue equals marginal cost.

Question 9

LOS 15. b: Explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure. Define marginal cost.

Answer 9

The marginal cost of production is the change in total cost that comes from making or producing one additional item. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale. The calculation is most often used among manufacturers as a means of isolating an optimum production level.

Question 10

LOS 15. b: Explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure. Define economic profit.

Answer 10

An economic profit or loss is the difference between the revenue received from the sale of an output and the opportunity cost of the inputs used. In calculating economic profit, opportunity costs are deducted from revenues earned. Opportunity costs are the alternative returns foregone by using the chosen inputs, and as a result, a person can have a significant accounting profit with little to no economic profit.

Question 11

LOS 15. b: Explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure. Perfect competition.

Answer 11

Perfect competition

Price = marginal revenue = marginal cost (in equilibrium)

Perfectly elastic demand, zero economic profit in equilibrium

Question 12

LOS 15. b: Explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure. Monopolistic competition.

Answer 12

Monopolistic Competition

Price > marginal revenue = marginal cost (in equilibrium)

Elasticity > 1 (elastic but not perfectly elastic), zero economic profit in long-run equilibrium

Question 13

LOS 15. b: Explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure. Oligopoly

Answer 13

Oligopoly

Price > marginal revenue = marginal cost (in equilibrium)

Elasticity > 1 (elastic), may have positive economic profit in long-run equilibrium, but moves toward zero economic profit over time.

Question 14

LOS 15. b: Explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure. Monopoly

Answer 14

Monopoly

Price > marginal revenue = marginal cost (in equilibrium)

Elasticity > 1 (elastic), may have positive economic profit in long-run equilibrium, profits may be zero because of expenditures to preserve monopoly.

Question 15

LOS 15. c: Describe a firm’s supply function under each market structure.

Answer 15

Under perfect competition, a firm’s short-run supply curve is the portion of the firm’s short-run marginal cost curve above average variable cost. A firm’s long -run supply curve is the portion of the firm’s long run marginal cost curve above average total cost.

Firms operating under monopolistic competition, oligopoly, and monopoly do not have well-defined supply functions, so neither marginal cost curves nor average cost curves are supply curves in these cases.

Question 16

LOS 15. d: Describe and determine the optimal price and output for firms under each market structure

Answer 16

All firms maximize profits by producing the quantity of output for which marginal cost equals marginal revenue. Under perfect competition (perfectly elastic demand), marginal revenue equals price.

Firms in monopolistic competition or that operate in oligopoly or monopoly markets all face downward-sloping demand curves. Selling price is determined from the price on the demand curve for the profit maximizing quantity of output.

Question 17

LOS 15. e: Explain factors affecting long-run equilibrium under each market structure.

Answer 17

An increase (decrease) in demand will increase (decrease) economic profits in the short run under all market structures. Positive economic profits result in entry of firms into the industry unless barriers to entry are high. Negative economic profits result in exit of firms from the industry unless barriers to exit are high. When firms enter (exit) an industry, market supply increases (decreases), resulting in a decrease (increase) in market price and an increase (decrease) in the equilibrium quantity traded in the market.

Question 18

LOS 15. f: Describe pricing strategy under each market structure.

Answer 18

Whether a firm operates in perfect competition, monopolistic competition, or is a monopoly, profits are maximized by producing and selling the quantity for which marginal revenue equals marginal cost. Under perfect competition, price equals marginal revenue. Under monopolistic competition or monopoly, firms face downward-sloping demand curves so that marginal revenue is less than price, and the price charged at the profit-maximizing quantity is the price from the firm’s demand curve at the optimal (profit-maximizing) level of output.

Under oligopoly, the pricing strategy is not clear. Because firm decisions are interdependent, the optimal pricing and output strategy depends on the assumptions made about other firms’ cost structures and about competitors’ responses to a firm’s price changes. (Nash equilibrium)

Question 19

LOS 15. g: Describe the use and limitations of concentration measures in identifying market structure.

Answer 19

A concentration ratio for N firms is calculated as the percentage of market sales accounted for by the N largest firms in the industry and is used as a simple measure of market structure and market power.

The Herfindahl-Hirschman Index measure of concentration is calculated as the sum of the squared market shares of the largest N firms in an industry and better reflects the effect of mergers on industry concentration.

Neither measure actually measures market power directly. Both can be misleading measures of market power when potential competition restricts pricing power.

Question 20

LOS 15. h: Identify the type of market structure within which a firm operates.

Answer 20

To identify the market structure in which a firm is operating, we need to examine the number of firms in its industry, whether products are differentiated or other types of non-price competition exist, and marries to entry, and compare these to the characteristics that define each market structure.

Question 21

Define natural monopoly

Answer 21

A natural monopoly, like the name implies, is a monopoly that does not arise due to collusion, consolidation or hostile takeovers. Instead, natural monopolies occur when a company takes advantage of an industry’s high barriers to entry to create a “moat” or protective wall around its operations.

The utilities industry is a good example of a natural monopoly. The costs of establishing a means to produce power and supply it to each household can be very large. This capital cost is a strong deterrent for possible competitors. Additionally, society can benefit from having a natural monopoly like this because multiple utility companies operating in the same industry overleverage the available resources.

Question 22

Define Kinked demand curve model

Answer 22

The Kinked-Demand curve theory is an economic theory regarding oligopoly and monopolistic competition. Kinked demand was an initial attempt to explain sticky prices.

“Kinked” demand curves and traditional demand curves are similar in that they are both downward-sloping. They are distinguished by a hypothesized concave bend with a discontinuity at the bend - the “kink.” Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve.

Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly or monopolistic competition) will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve . In classical theory, any change in the marginal cost structure or the marginal revenue structure will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a “kink” exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity.

Question 23

Define Cournot duopoly model

Answer 23

The Cournot model has some significant advantages. The model produces logical results, with prices and quantities that are between monopolistic (i.e. low output, high price) and competitive (high output, low price) levels. It also yields a stable Nash equilibrium, which is defined as an outcome from which neither player would like to deviate unilaterally.

However, the model also has some drawbacks based on its assumptions that may be somewhat unrealistic in the real world. First, the Cournot classic duopoly model assumes that the two players set their quantity strategy independently of each other. This is unlikely to be the case in a practical sense. When only two producers are in a market, they are likely to be highly responsive to each other’s strategies rather than operating in a vacuum.

Second, Cournot shows that a duopoly could form a cartel and reap higher profits by colluding than from competing against each other. But game theory shows that a cartel arrangement would not be in equilibrium, since each company would tend to deviate from the agreed output (for proof, one need look no further than OPEC).

Third, the model’s critics question how often oligopolies compete on quantity rather than price. French scientist J. Bertrand in 1883 attempted to rectify this oversight by changing the strategic variable choice from quantity to price. The suitability of price, rather than quantity, as the main variable in oligopoly models was confirmed in subsequent research by a number of economists.

Finally, the Cournot model assumes product homogeneity with no differentiating factors. While Cournot developed his model after observing competition in a spring water duopoly, it is ironic that even in a product as basic as bottled mineral water, one would be hard-pressed to find homogeneity in the products offered by different suppliers.

Question 24

Define Nash equilibrium model (prisoner’s dilemma)

Answer 24

Nash Equilibrium is named after its inventor, John Nash, an American mathematician. It is considered one of the most important concepts of Game Theory, which attempts to determine mathematically and logically the actions that participants of a game should take to secure the best outcomes for themselves. The reason why Nash Equilibrium is considered such an important concept of Game Theory relates to its applicability. The Nash Equilibrium can be incorporated into a wide range of disciplines, from economics to the social sciences.

Nash Equilibrium

The Nash Equilibrium is the solution to a game in which two or more players have a strategy, and with each participant considering an opponent’s choice, he has no incentive, nothing to gain, by switching his strategy. In the Nash Equilibrium, each player’s strategy is optimal when considering the decisions of other players. Every player wins because everyone gets the outcome they desire. To quickly test if the Nash equilibrium exists, reveal each player’s strategy to the other players. If no one changes his strategy, then the Nash Equilibrium is proven.

For example, imagine a game between Tom and Sam. In this simple game, both players can choose strategy A, to receive $1, or strategy B, to lose $1. Logically, both players choose strategy A and receive a payoff of $1. If you revealed Sam’s strategy to Tom and vice versa, you see that no player deviates from the original choice. Knowing the other player’s move means little and doesn’t change either player’s behavior. The outcome A, A represents a Nash Equilibrium.

Prisoner’s Dilemma

The Prisoner’s Dilemma is a common situation analyzed in Game Theory that can employ the Nash Equilibrium. In this game, two criminals are arrested and each is held in solitary confinement with no means of communicating with the other. The prosecutors do not have the evidence to convict the pair, so they offer each prisoner the opportunity to either betray the other by testifying that the other committed the crime or cooperate by remaining silent. If both prisoners betray each other, each serves five years in prison. If A betrays B but B remains silent, prisoner A is set free and prisoner B serves 10 years in prison, or vice versa. If each remains silent, then each serves just one year in prison. The Nash equilibrium in this example is for both players to betray each other. Even though mutual cooperation leads to a better outcome, if one prisoner chooses mutual cooperation and the other does not, one prisoner’s outcome is worse.

Question 25

Define Stackelberg dominant firm model

Answer 25

The Stackelberg leadership model is a strategic game in economics in which the leader firm moves first and then the follower firms move sequentially. It is named after the German economist Heinrich Freiherr von Stackelberg who published Market Structure and Equilibrium (Marktform und Gleichgewicht) in 1934 which described the model.

In game theory terms, the players of this game are a leader and a follower and they compete on quantity. The Stackelberg leader is sometimes referred to as the Market Leader.

There are some further constraints upon the sustaining of a Stackelberg equilibrium. The leader must know ex ante that the follower observes its action. The follower must have no means of committing to a future non-Stackelberg follower action and the leader must know this. Indeed, if the ‘follower’ could commit to a Stackelberg leader action and the ‘leader’ knew this, the leader’s best response would be to play a Stackelberg follower action.

Firms may engage in Stackelberg competition if one has some sort of advantage enabling it to move first. More generally, the leader must have commitment power. Moving observably first is the most obvious means of commitment: once the leader has made its move, it cannot undo it - it is committed to that action. Moving first may be possible if the leader was the incumbent monopoly of the industry and the follower is a new entrant. Holding excess capacity is another means of commitment.