The Firm and Market Structure Flashcards
The market structure is classified into four categories:
- perfect competition
- monopolistic competition
- oligopoly
- monopoly
The five factors that determine market structure:
- the number and relative size of firms supplying the product
- the degree of product differentiation
- pricing power of the sellers - price takers or setters
- the relative strength of the barriers to market entry and exit
- the degree of non-price competition
Number of sellers under
- perfect competition
- monopolistic competition
- oligopoly
- monopoly
perfect competition
- many firms
monopolistic competition
- many firms
oligopoly
- few firms
monopoly
- single firm
Barriers to entry and exit under
- perfect competition
- monopolistic competition
- oligopoly
- monopoly
perfect competition
- very low
monopolistic competition
- low
oligopoly
- high
monopoly
- very high
Non-price competition under
- perfect competition
- monopolistic competition
- oligopoly
- monopoly
perfect competition
- none
monopolistic competition
- advertising and product differentiation
oligopoly
- advertising and product differentiation
monopoly
- advertising
Pricing power under
- perfect competition
- monopolistic competition
- oligopoly
- monopoly
perfect competition
- none; price taker
monopolistic competition
- some
oligopoly
- some to significant
monopoly
- considerable
Examples of
- perfect competition
- monopolistic competition
- oligopoly
- monopoly
perfect competition
- oranges, milk, wheat
monopolistic competition
- toothpaste
oligopoly
- commercial airlines for a given route
- coke v pepsi
monopoly
- utility provider; provider controlled by a government authority
Product differentiation under
- perfect competition
- monopolistic competition
- oligopoly
- monopoly
perfect competition
- homogeneous
monopolistic competition
- substitutes but differentiated
oligopoly
- close substitutes or differentiated
monopoly
- unique product
Producers prefer which market structures and why
- monopoly / oligopoly because they offer the highest pricing power
Consumers prefer which market structures and why
- perfect competition as prices are lower
More substitutes means …
higher elasticity
The greater the portion of the consumer’s budget spent, means the good is
- more elastic
- expensive goods/cars are highly elastic
- a 10% increase in the price of cars and cereals will affect the demand for cars but not that of cereals
The longer the time period, the
higher the elasticity
For normal goods, income elasticity is
is positive
For inferior goods, income elasticity is
is negative
If cross-price elasticity of demand is positive,
- the two products are substitutes
- cereals and oats
If cross-price elasticity of demand is negative, t
then the two products are complements
- cereals and milk
Consumer surplus
- the difference between the price that consumers are willing to pay (value) and the price they actually pay (expenditure)
- on a supply and demand curve, it is the area beneath the demand curve and above the price paid
find the area of that triangle
Under perfect competition, the optimal quantity to sell is
- is determined by the firm’s own cost curves
Under perfect competition, the MC curve intersects the ATC curve at
- at the ATC curve’s minimum point
Perfect comp profit max condition is:
MR = MC
Under perfect comp, if the price of the product is 4 and ATC is 5, will the firm sell the product?
- no. which is why the supply curve is an MC curve above the minimum point of ATC
Monopolistic competition
Supply, demand, optimal pricing, and optimal output keys:
- many sellers and slightly differentiated products: KFC, McDonalds, Burger K, etc
- differentiate products through advertising and other non-price strategies
- downward sloping demand curve, and MR curve is steeper and below the demand curve
- profit max quantity is MR = MC
- price is determined on demand curve
- supply function is not well-defined in monopolistic comp
- the firm’s supply curve must show the Q the firm is willing to supply at various prices
- but the optimal output is still the intersection of MR and MC
- long-run economic profit is 0
Oligopoly demand analysis and pricing strategies
- has few sellers of a product and many buyers
- sellers are large payers in their industry: airlines and credit card companies, coke and pepsi
- products are close substitutes and by be differentiated by brand or be homogeneous and unbranded
- substantial pricing power
- pricing decisions are interdependent
- marketing is key
- there is temptation to collude
The models that try to explain pricing in oligopoly markets:
- pricing interdependence
- Cournot assumption
- nash equilibrium
- Stackelberg model
Pricing interdependence
Oligopoly model
Pricing interdependence - AKA kink demand curve (two different demand curves)
- competitor will not follow a price increase, but will cut prices in response to a price decrease
- at the kink in the demand curve, that point is called the stable price, above it, demand is elastic, and below to the right is less elastic
- profit max: MR=MC
- advantage: helps explain stable prices
- disadvantage: it does not tell us what prices should be
Cournot Assumption
- Oligopoly markets
The Cournot model describes a special case of Nash equilibrium, in which no firm can increase profits by changing its price/output choice.
- firms compete simultaneously to determine a profit-maxing output, based on the assumption that the other firm’s output will not change
- in the LR, changes in P or Q will NOT increase profits
- as the number of firms in an oligopoly increase, the equilibrium point moves closer to perfect competition
Nash equilibrium in a duopoly market
- Oligopoly
- a set of choices/strategies among two or more participants is called a Nash Equilibrium
- holding the strategies of all other participants constant, no participant has an incentive to choose a different strategy
Assumptions: - the firms do the best they can, given the actions of their rivals
- the actions are interdependent
- the firms do not collude; each frim wants to max its own profits
Stackelberg Model
- there is one dominant large firm and many small firms.
- the large firm sets the price and has the first-mover advantage
- the decision-making happens sequentially (not simultaneously)
- the leader firm chooses the output first and then the follower firm chooses its output
Oligopoly supply analysis and output and LR equilibrium
- the supply function is not well defined
- we cannot determine equilibrium output and price without considering the demand f and competitive strategies
- profit max condition is MR = MC
- the equilibrium price is based on the demand curve
- the dominant firm is the low-cost leader and price maker and will supply x amount while the follower firms will supply the rest
- as prices fall, the dominant firm picks up more market share as followers leave the industry
- LR economic profits are possible, but overtime the market share of the dominant firm declines
Monopoly market demand and supply and optimal price and output
- single seller, high barriers to entry, considerable pricing power, utility provider, patent or copyright, control over critical resources, strong brand loyalty, network effect (microsoft)
- demand curve is downward sloping
- the avg revenue is the same as the demand curve
- optimal output is MR = MC, or where (profit / quantity) = 0
- max profit = P = (MC / (1 - 1/E))
E is own-price elasticity
First-degree price discrimination
- the consumer is charged the max that they are willing to pay; seller captures all consumer surplus; ie no consumer surplus remains
- consumers are charged different prices for the same product (airline tickets)
- public price disclosure may not be permitted, so one consumer is aware of how much another consumer is paying for the same product; monopolist sells for what each consumer is willing to pay
Second-degree price discrimination
- the monopolist is not able to measure the consumer’s exact preferences or their willingness to pay before pricing the product
- the consumer is charged differently based on how much they value the product; ie a TI BAII Plus Prof
- the consumer is charged differently based on quantity sold; quantity discounts
- there is some amount of consumer surplus
Third-degree price discrimination
- ## consumers are segregated based on demographic or other traits (gender, age); business travels v normal, student v prof versions of software packages
A firm is a monopoly with high barriers to entry. MC=$25, AC= $38. Price elasticity of demand = 1.15. The firm will most likely set its price at:
Max profit = P= (MC / ((1- (1/E))) =
25 / (1 - ((1/1.15))) = 25 / .1304
Price = $192
Approaches to measuring market concentration or market power
- regression analysis
- N-firm concentration ratio
- Herfindahl-Hirshman index (HHI)
N-frim “concentration ratio”:
- the sum of the market shares of the largest N firms.
- this is almost 0 for perfect competition and 100 for monopoly
advantages: - data is easily available
- simple to understand
disadvantages: - unaffected by mergers among top fimrs
- does not quantify market power
- does not consider barriers to entry
- does not consider elasticity of demand
The market share of firms in industry before a merger between A and B:
A: .35, B: .28, C: .15, D: .12, E: .07, F: .03
Q: what is the 4 firm concentration ratio after A&B merge?
AB: .63, C: .15, D: .12, E: .07,
sum = .97 concentration ratio
a disadvantage of the n-firm concentration ratio is that it fails to reflect the effect of mergers
Herfindahl-Hirschman Index (HHI)
- the SUM of squared market shares of N largest firms in a market (0-1).
- a number close to 1 indicates it is concentrated or monpolistic
advantages: - simple and commonly used by regulators disadvantages - does not consider barriers to entry - does not consider elasticity of demand
Find the 3 firm HH index:
A: .30 B: .25 C: .20 D: .15 E: .10
the 3 firm HHI is:
.3^2 + .25^2 + .20^2
= 19.25%
Analyst 1: For firms operating under monopolistic competition, the supply curve is equal to the average cost curve.
Analyst 2: For firms operating under monopolistic competition, the supply curve is equal to the marginal cost curve.
Which analyst is most likely correct?
C is correct. Firms operating under monopolistic competition do not have well-defined supply functions, so neither the marginal cost curve nor the average cost curves are supply curves in this market structure.
Two analysts make the following statements:
Analyst 1: Compared to perfect competition, monopolies are always inefficient.
Analyst 2: Monopolies may sometimes be more efficient than perfect competition.
Which analyst is most likely correct?
B is correct. Economies of scale and regulation may sometimes make monopolies more efficient than perfect competition.
A market structure characterized by few sellers and high barriers to entry into or exit from the industry is best described as:
A. monopolistic
B. oligopoly
C. monopoly
B is correct. In an oligopoly, we have relatively few sellers and the barriers to entry into or exit from the industry are high.
In monopolistic competition, there are many sellers, and the barriers to entry and exit are fairly low.
In a monopoly, there is only one seller, and the barriers to entry and exit are very high.
