2.2 the firm and market structures Flashcards
Economists’ Four Types of Structure
Perfect Competition
Monopolistic Competition
oligopoly
monopoly
Perfect Competition
Markets with perfect competition have homogeneous (i.e., identical) products with no producer large enough to influence the price
Profits are driven to the minimum required to raise capital
Monopolistic Competition
This type of market also has a large number of firms, but the products are differentiated
Soft drinks and cosmetics fall into this category.
oligopoly
The oligopoly market structure has only a few firms supplying the market. Retaliatory strategies must be considered when changing prices or production levels
The airline industry is an oligopoly.
Monopoly
This is the least competitive market structure. There is a single seller and no substitutes for the product. The seller has much control over the prices, but often regulated by governments
Local utility companies often fall into this category.
Factors that Determine Market Structure
Numbe of Sellers
Degree of Product Differentiation
Barriers to Entry
Pricing Power of Firm
Non-Price Competition
Perfectly competitive markets will lead to which type of demand curves
horizontal demand schedules
At a given price, the quantity demanded is infinite.
For example, a farmer can sell all his corn at the market price but none at a higher price
Vertical demand schedules
exist when a fixed quantity is demanded, regardless of the price.
For example, a diabetic consumer that relies on insulin will not consume less if the price goes up.
This is a case of perfect price inelasticity
Consumer surplus
the value placed on the units purchased less the amount paid.
It represents the “bargain” earned by consumers that pay less than they would be willing to pay
a marginal value curve
The negatively sloped demand curve can be considered a marginal value curve because it shows the highest price a consumer would be willing to pay for each additional unit
Supply Analysis in Perfectly Competitive Markets
The supply functions for individual firms have positive slopes.
This means when the price per unit increases, the firms will supply a greater quantity of the product
Optimal Price and Output in Perfectly Competitive Markets
The market supply and demand functions can be set equal to each other to find the equilibrium price and quantity
The demand curve faced by each firm in a perfectly competitive market is horizontal, even if the whole market demand curve is downward sloping
Factors Affecting Long-Run Equilibrium in Perfectly Competitive Markets
In the long run, as more firms enter into a perfectly competitive market, the industry supply curve will shift to the right (more quantities are produced with the same price) and a perfectly competitive firm will operate with zero economic profit
The equilibrium price will equal the marginal cost, which will also equal the minimum average cost
Demand Analysis in Monopolistically Competitive Markets
The demand curve for each firm will have a negative slope – lowering the price will increase the quantity demanded.
Demand is more elastic at higher prices
The profit-maximization point in the short run in Monopolistically Competitive Markets
where marginal revenue equals marginal cost
Supply Analysis in Monopolistically Competitive Markets
In monopolistic competition, the supply function is not well-defined. The price charged is based on the market demand schedule. The firm must calculate the optimal quantity to supply at various prices
Factors Affecting Long-Run Equilibrium in Monopolistically Competitive Markets
Economic profit will attract competition.
In the long run, economic profit will fall to zero in monopolistically competitive markets.
However, the equilibrium quantity will be less than it would be in a market with perfect competition
three pricing strategies in non-colluding oligopoly markets
Pricing Interdependence
Cournot Assumption
Game Theory/Nash Equilibrium
Pricing Interdependence
This situation exists in any market with price wars.
–> A common example is airlines that serve the same cities
It is common to assume competitors will match price reductions and ignore price increases. This means market share will increase when competitors increase their prices but stay about the same when price drops are matched
the effect of pricing Interdependence on elasticity
the elasticity is greater for price increases than decreases.
Cournot Assumption
each firm determines its profit-maximizing production level assuming all the other firms will not change their output.
In the long run, the equilibrium output and price are stable
The equilibrium price under the Cournot assumption
will be between the equilibrium prices of the monopoly and competitive market.
As the number of firms increases, the Cournot equilibrium price will move closer to the competitive market equilibrium price
Game Theory/Nash Equilibrium
the pricing strategy is set when no firm has an incentive to change.
Each firm does the best it can given the reaction of its rivals
This approach assumes each firm is acting in their own best interest without price collusion. The resulting market equilibrium may not maximize the total profits for all firms.
cartels
Open collusive agreements
Collusion is more likely to be successful under the following conditions
- There are just a few firms or one of the firms is dominant.
–> Firms should not all have similar market shares. Otherwise, the competitive forces would overshadow the benefits of collusion.
- Products are homogeneous.
- Firms have similar cost structures.
- Order sizes are small and deliveries are frequent.
- There is a threat of severe retaliation from competitors for breaking a collusive agreement.
- Collusion among incumbent firms is likely to be a barrier to new entrants
The Stackelberg model
another potential strategy based on game theory.
This theory assumes moves are made sequentially, whereas Cournot assumes they are made simultaneously.
Under the Stackelberg model, the leader firm has a distinct advantage
Supply Analysis in Oligopoly Markets
The optimal output for a firm in an oligopoly market is dependent on the demand conditions and the competitor’s strategies
when is profit maximized in an Oligopoly?
Profit is still maximized when marginal revenue equals marginal cost
The dominant (or leader) firm in an Oligopoly
generally is the price maker
Typically, the dominant firm has a lower cost structure, which makes it unlikely other firms will start a price war
The dominant firm will set the price where its marginal cost equals its marginal revenue
The total market demand curve will have a steeper slope than for the leader because the leading firm will capture a larger percentage of the total market at lower prices
Optimal Price and Output in Oligopoly Markets
Optimal Price and Output in Oligopoly Markets
Factors Affecting Long-Run Equilibrium in Oligopoly Markets
Over time, the market share of the dominant firm typically declines as other firms become more efficient
Pricing wars should be avoided because they only lead to temporary market share gains
To maintain their dominant positions, oligopolistic firms must innovate.
Supply Analysis in Monopoly Markets
The profit is maximized when marginal revenue equals marginal cost
Demand Analysis in Monopoly Markets
The monopolist’s demand schedule is the aggregate demand for the product. It has a typical negative slope.
The marginal revenue has a steeper slope, and it is twice as much if the demand schedule is linear
how to find the the marginal revenue and marginal cost in a Monopoly market?
Both the marginal revenue and marginal cost can be calculated by taking the derivative of the total revenue and total cost function
The optimal output and price can be calculated by setting the marginal revenue equal to the marginal cost
first-degree price discrimination
the monopolist charges a price to take the entire consumer surplus
A different price is charged to each client depending on the highest price they are willing to pay for a product
second-degree price discrimination
the monopolist allows consumers to select various options of quantity or quality.
Consumers that value the product more are charged more.
Third-degree price discrimination
segregates consumers by demographic or other traits
Factors Affecting Long-Run Equilibrium in Monopoly Markets
An unregulated monopoly structure can maintain its position over the long run by using substantial barriers to entry
Governments tasked with regulating monopolies have a number of long-run solutions
Government solutions against Monopoly barriers to entry
- Set price equal to marginal cost: Subsidies will be required if the marginal cost is less than the long-run average cost (LRAC).
- Nationalization: Government ownership often hinders the monopoly’s ability to impose politically unpopular price increases.
- Authorized monopolies: If the price is set to equal LRAC, investors will earn a normal profit for their level of risk. However, it can be difficult for regulators to determine a realistic LRAC.
- Franchising monopolies through a competitive bidding process: Examples include retail stores at airports and rail stations.
The concentration ratio
the sum of the market shares of the N largest firms
The result will be a number between 0 and 1.
However, a high concentration ratio does not necessarily imply market power. Just the threat of new entrants could force a firm to act in a competitive manner.
Also, the ratio is not affected by the mergers of the top players in the market
The Herfindahl-Hirschman index (HHI)
attempts to fix some of the issues with the concentration ratio
The HHI is the sum of the squared market shares of the
largest firms
The HHI still does not take into account the possibility of new entrants
