Chapter 8 Flashcards
Monopolistic competition
each firm has some choice over what price to charge for its products.
Assumptions of monopolistic competition
There are quite a large number of firms > small market share. Independence, it doesn’t have to worry about how rivals will react.
There is freedom of entry.
Product differentiation.
i.e. restaurants.
Limitations of the model
Information may be imperfect.
Given that firms in the industry produce different products, it is difficult to derive a demand curve for the industry as a whole.
Firms are likely to differ from each other not only in the product they produce or the service they offer, but also in their size and cost structure. Entry may not be completely unrestricted.
One of the biggest problems with the simple model is that is concentrates on price and output decisions. (in reality, exact variety + advertising) > non-price competition.
Non-price competition
Product development – produce a product that will sell well and is different.
Advertising – sell the product.
The optimal amount of advertising is where the revenue from additional advertising (MRa) is equal to its costs (MCa). As long as MR>MC it will add extra profit.
Two problems:
The effect of product development and advertising on demand will be difficult for a firm to forecast.
Product development and advertising are likely to have different effects at different prices.
Monopolistic competition leads to a less efficient allocation of resources than perfect competition.
Monopolistic competition has two disadvantages
Less will be sold and at a higher price.
Firms will not be producing at the least-cost point.
Excess capacity
by producing more, firms would move to a lower point on their LRAC curve.
Oligopoly
occurs when just a few firms between them share a large proportion of the industry. The firms may produce a virtually identical product. Most oligopolies produce differentiated products.
Two features that distinguish an oligopoly form other market structures
Barriers to entry – similar to that of a monopoly.
Interdependence of the firms – each firm is affected by its rivals’ actions. This will affect their decisions.
The interdependence of firms in an oligopolistic market pulls them in two very different directions:
Each firm believe that by competing it can gain a greater share of industry profits.
Competition will be destructive and lead to lower profits. They may prefer to collude with each other making agreements > maximize industry profits.
Collusive oligopoly
where oligopolists agree to limit competition between themselves. They may set up quotas, fix prices, limit product promotion or development, or agree not to poach each other’s markets.
Cartel
a formal collusive agreement.
Cartel’s MC curve is horizontal sum of the MC curves of members.
Maximum profit is at MC=MR.
Cartel members may somehow agree to divide the market between them > quota = the output that a given member of a cartel is allowed to produce or sell.
Tacit collusion
where oligopolists take care not to engage in price cutting, excessive advertising or other forms of competition. There may be unwritten rules of collusive behavior such as price leadership.
Dominant firm price leadership
where firms choose the same price as that set by the dominant firm in the industry. > MC=MR
Barometric firm price leadership
where the price leader is the one whose prices are believed to reflect market conditions in the most satisfactory way.
Rules of thumb
do not involve setting MC equal to MR, and thus may involve an immediate loss of profit. They help to prevent an outbreak of competition and help to maintain profits into the long-term.
Average cost pricing
where a firm sets it price by adding a certain percentage profit on top of average cost.
Price benchmark
a price that is typically used. Firms, when raising a price, will usually raise it from one benchmark to another.
If the following conditions apply it will be easier for firms to collude:
There are only very few firms all well known to each other.
They are not secretive with each either about costs and production methods.
They have similar production methods and average costs and are thus likely to want to change prices at the same time and by the same percentage.
They produce similar products and can thus more easily reach agreements on price.
There is a dominant firm.
There are significant barriers to entry and therefore little fear of disruption by new firms.
The market is stable.
There are no government measures to curb collusion.
Non-collusive oligopoly
where oligopolists have no agreement between themselves, formal, informal or tacit.
The danger with selling above quota or cutting price is that this would invite retaliation from the other members of the cartel, with resulting price war. Price would then fall, and the cartel could break up in disarray.
Kinked demand theory
the theory that oligopolist face a demand curve that is kinked at the current price, demand being significantly more elastic above the current price than below. The effect of this is to create a situation of price stability.
If an oligopolist cuts price, rivals will follow.
If an oligopolist raises price its rivals will not follow.
The model has two major limitations
Price stability may be due to other factors.
The model does not explain how prices are set in the first place.
Disadvantages of an oligopoly
Depending on the size of the individual oligopolists, there may be less scope for economies of scale to mitigate the effects of market power.
Oligopolists are likely to engage in much more extensive advertising than a monopolist.
Countervailing power
where the power of a monopolistic/oligopolistic seller is offset by powerful buyers who can prevent the price from being pushed up.
Advantages of an oligopoly to society
Oligopolists can use part of their supernormal profit for research and development.
Non-price competition through product differentiation may result in greater choice for the consumer.
Game theory
a mathematical method of decision making in which alternative strategies are analysed to determine the optimal course of action for the interested party, depending on assumptions about rivals’ behavior.
Widely used in economics, game theory is also used as the tool in biology, psychology and politics.
Simultaneous single-move game
a game where each player has just one move where each player plays at the same time and acts without knowledge of the actions chosen by other players.
Dominant strategy
where the firm’s optimal strategy remains the same, irrespective of what it assumes its rivals are going to do. One of the best ways of illustrating this idea is to represent the strategic environment facing the firms as a normal-form game = where the possible payoffs from different strategies or decisions are presented as a matrix.
Prisoners’ dilemma
where two or more firms, by attempting independently to choose the best strategy, think about what their rivals are likely to do, end up in a worse position than if they had co-operated in the first place.
Nash equilibrium
This is the position that results from everyone making their optimal decision based on their assumptions about their rivals’ decisions.
If a firm’s behavior was different from its expected behavior, then the decisions of its rivals do not represent a Nash equilibrium.
The difference between a single-move game and a repeated move gave is that each firm can now see what its rivals did in previous periods.
Trigger strategy
once a firm observes that its rival has broken some agreed behavior it will never co-operate with them again.
Backwards induction and movement to the Nash equilibrium
a process by which firms think through the most likely outcome in the last period of competition and then work backwards step by step thinking through the most likely outcomes in earlier periods of competition.
Sequential move game
one firm makes and implements a decision. Rival firms can observe the actions taken by the first mover before making their own decisions.
Decision tree (game tree)
a diagram showing the sequence of possible decisions by competitor firms and the outcome of each combination of decisions.
First-mover advantage
when a firm gain from being the first one to take action.
Credible threat
one that is believable to rivals because it is in the threatener’s interest to carry it out.
Maximin
the strategy of choosing the policy whose worst possible outcome is the least bad. Maximin is usually a low-risk strategy.
Maximax
the strategy of choosing the policy that has the best possible outcome. Maximax is usually a high-risk strategy.
Uniform pricing
firms sell each unit of output for the same price.
Price discrimination
where a firm sells the same product at different prices.
Three different types of price discrimination
First-degree price discrimination
Second-degree price discrimination
Third-degree price discrimination
First-degree price
This is where the seller of the product charges each consumer the maximum price her or she is prepared to pay for each unit. It is sometimes called perfect price discrimination or personalized pricing.
Second-degree price discrimination
This where a firm offers consumers a range of different pricing options for the same or similar product. Customers are then free to choose whichever option they wish, but the price is often dependent on some factor such as:
The quantity of the product purchased.
The use of coupons/vouchers.
When the product is purchased.
The version of the product purchased.
Third-degree price discrimination
This is where a firm divides consumers into different groups based on some characteristics that is:
Relatively easy to observe
Informative about consumers’ willingness to pay
Legal
Acceptable to the consumer
i.e. age, gender, nationality, location, occupation, business/individual, past buying behavior.
Peak-load pricing
price discrimination (2nd, 3rd) where a higher price is charged in peak periods and a lower price in off-peak periods.
Under what circumstances will it be able to charge discriminatory prices
The firm must be able to set its price. Thus, impossible under perfect competition
The markets must be separable > people in the low-priced market must not be able to resell the product in the high-priced market.
Demand elasticity must differ in each market. Higher price when less elastic, thus less sensitive to a price rise.
The effects of price discrimination on the following aspects of the market:
Distribution effects on those customers who previously purchased the good at a uniform price > will feel like it’s unfair and their consumer surplus is lower.
Previously purchased the good but are now paying a lower price will feel better of > consumer surplus will be higher.
The impact of any extra sales > positive impact on the welfare of the society > will increase profit and consumer surplus.
Misallocation effects > people with a high valuation of the good could but it from those consumers with a lower valuation of the good, at a price that would improve both parties’ welfare. The seller blocks this resale from taking place and in the process reduces society’s welfare.
Competition. Predatory pricing = where a firm’s sets its prices below average cost in order to drive competitors out of business.
Price discrimination raises a firm’s profits. Could be seen as an undesirable redistribution of income in society. On the other hand, the higher profits may be reinvested and lead to innovation or lower costs in the future.
