Market Structure

1. Market Structure Theoretical Market Structures • Pure Competition • Pure Monopoly • Monopolistic Competition • Oligopoly

2. Areas to Cover • What are the theoretical market structures and their assumptions? • What are the social and economic problems of noncompetitive markets? • How do we measure market structure? • How do firms behave (price, invest, and promote) under the different market structures? • What are contestable markets?

3. What goods can be distributed efficiently through markets?Private Goods vs. Public Goods • Private Goods- consumption by one excludes consumption by others (bread) • Public Goods- consumption is nonrival(national defense) • Mixed Goods- elements of both private and public goods • Markets work well in providing private goods but often fail to provide the optimal levels of public goods.

4. Market Structure- degree of competition in the market • 1. Pure Competition a. large number of buyers and sellers (sellers act as price takers) b. perfect knowledge c. easy entry and exit d. homogeneous product

5. 2. Pure Monopoly- single producer of a good with no substitutes (Microsoft Operating System?) 3. Monopolistic Competition- many firms (like pure competition) and differentiated product (like pure monopoly) (local Wendy’s) 4. Oligopoly- small number of firms in which each firm reacts to competitors’ price, output, adv., etc. (Ford, Kelloggs, …)

6. Economic Arguments for Competition • Productionoperations are efficient • Promotional expenses are not excessive • Profits are just sufficient to reward investment, efficiency, and innovation • Output levels and quality are responsive to consumers • Opportunities for introducing technically superior products and processes

7. Structure, Conduct, and Performance Paradigm Structure Conduct Performance

8. Public Policy implications of market structure- traditional view • 1. Market Structureleads to certain forms of Market Conduct (pricing, promotional and investment decisions, etc.) • Competition/Monopoly leads to low/high prices • 2. Market Conduct leads to Market Performance High/Low prices lead to large/small allocative inefficiency • 3. Market Performance includes: • a. Allocative efficiency • b. Excess capacity • c. Technical efficiency and innovation

9. Allocative Efficiency- measured by social loss, welfare loss or deadweight loss 1. In monopoly situation, deadweight loss is dollar value of economic loss to society due to a monopolist restricting output by raising its price above marginal cost. • The monopolist restricts its output below that which would occur under a competitive market structure. • The monopolist restricts its output below the competitive market level in order to keep prices high and maximize profit

10. Deadweight Loss $/Q Deadweight Loss (area of triangle) = .5(11.5-6.5)(4-2.5) = 3.75 Marginal Cost Demand Curve Marginal Rev. Quantity

11. Factors determining market structure: (1) number of buyers and seller and (2) barriers to entry 1. Number of buyers and sellers a. Concentration Ratios- percentage of value of industry shipments accounted for by the "x" largest firms where "x" is 4, 8, or 20.

12. Selected Examples of Concentration Ratios in the U.S., 1972 and 1982 • Percent of value of the largest • Industry No. of Firms 4 firms 8 firms • 1972 Motor Vehicles 165 93 99 • 1982 284 92 97 • 1972 Cereal Breakfast Foods 34 90 98 • 1982 32 86 - • 1972 Pet Food 147 51 71 • 1982 222 52 71 • 1972 Aircraft 141 66 86 • 1982 139 64 81 • 1982 Chewing Gum 9 95 -

13. b. Herfindahl index (HHI)- the sum of the squares of the market shares of all firms • atomistic competition is 0 • monopoly is 10000 • a duopoly with 70 percent and 30 percent is 5800 (70)2 + (30)2 = 4900 + 900 = 5800

15. 1982 and 1992 DOJ Merger Guidelines • delineation of relevant markets for merger analysis so as to determine whether the merger partners compete with each other • seller concentration

16. DOJ 1992 Guidelines Use of HHI • The Guidelines specify DOJ’s two decision points: • For a market with a post-merger HHI below 1000, the merger will ordinarily not be challenged • For a market with a post-merger HHI above 1800 and the merger itself causing in the HHI an increase of 100 or more, the merger is likely to be challenged

17. Federal Trade Commission v. Staples and Office Depot (1997) • Relevant Geographic Market- metropolitan areas • geographic market “to which consumers can practically turn for alternative sources of the product.” • Relevant Product Market- sale of consumable office productsthrough office superstores • “The general rule … is that the outer boundaries of a product market are determined by the reasonable interchangeability of use or the cross-elasticity of demand…” • District Court Agrees with FTC • Staples and Office Depot – overall sale of office products (including Best Buy, Wal-Mart, Target, …) where Staple-OD account for only 5.5% of market • Given relevant market as defined by Court as office superstores • Current HHI: Least Concentrated 3597 Most Concentrated 6944 • After HHI: Least Concentrated 5003 Most Concentrated 10000 15 Metro Areas • If relevant markets were: Staples, Office Depot, Office Max, Price Cosco, Sam’s, BJ’s, Best Buy, Wal-Mart, Kmart, Target, Circuit City, Computer City, CompUSA and independent office supply dealers • Least concentrated HHI: 1793 Most Concentrated HHI: 5047 • Avg. Increase: 861 • “The Merger Guidelines, of course, are not binding on the Court, but they do provide a useful illustration of the application of the HHI,… and the Court will use that guidance here.”

18. 2. Barriers to Entry a. Sunk Cost- the need to sink money into an enterprise imposes a difference in incremental cost and incremental risk between an incumbent and a new entrant. • The incremental cost as seen by the • new entrantincludes the full amount of the sunk cost (since it is not yet sunk) but • incumbent does not consider sunk costs • Investment in sunk assets sends signals • Incumbent that buys equipment today signals that it will be around tomorrow since it cannot resell the equipment. • New entrantsmay interpret the equipment purchase as bad news about the profitability of the market and may not enter.

19. $/Q Average Cost • b. Scale Economies Increase Concentration c. Absolute Cost Barriers 1) Patents 2) Control of inputs d. Product Differentiation Demand Q

20. a. large number of buyers and sellers • (sellers act as price takers) • b. perfect knowledge • c. easy entry and exit • d. homogeneous product • Pure Competition S P D (1) market price is determined by the interaction of supply and demand (2) Purely competitive firm’s output level: set P=MC if MC > SAVC Firm can sell all that it wants at the prevailing market price, P Firm will never price below market price, P Market Price (P) equals firm’s Marginal Revenue (MR) Firm’s decision is to determine its optimal quantity, Q. Q S MC SAC SAVC D Q

21. Competitive EquilibriumIndustry Supply Curve is horizontal sum of firms’ marginal cost curves Industry Demand MC2 MC1 Industry Supply P Q2 Q1 Q1+Q2

22. Pure CompetitionFirms set output where price = marginal cost if price > aver. variable cost If P = 10, then Q = 12 and excess profits and new entry of new firms If P = 4, firm produces Q = 0

23. MONOPOLY Monopoly- firm demand is the industry demand 1. Decison Rule for profit maximization a. MR = MC if P > SAVC • b. Reinvest as long as projected P > LAC 2. Price discrimination, i.e., charging different customers different prices, modifies the above rules. 3. Two social problems of monopoly • a. distributional aspects: who get the benefits of • production and consumption (the firm with excess profits • or the consumer with added consumer surplus) b. allocative inefficiency: too small output (deadweight loss)

24. Deadweight Loss $/Q Deadweight Loss (area of triangle) = .5(11.5-6.5)(4-2.5) = 3.75 Marginal Cost Demand Curve Marginal Rev. Quantity

25. Problems of Natural Monopoly(with decreasing average costs) 4. A natural monopoly producing a single product is a monopoly with increasing returns to scale or decreasing average cost. With scale economies, only two of the following three can occur • a. economically efficient output (no deadweight loss) • b. no financial losses to firm (TR TC) • c. single price to all customers

26. Natural Monopoly Dilemmas $/Q Average Cost Marginal Cost Demand Marginal Revenue Quantity Profit Max Break Even Efficient

27. Natural Monopoly Dilemma:Profit-Maximizing Single Price (P=8) where Marginal Revenue = Marginal Cost $/Q Average Cost Deadweight Loss Marg. Cost Demand MR Quantity Profit Max Efficient

28. Natural Monopoly DilemmaTotal Revenue = Total Cost and Single Price (P=6) where Price (Demand) = Average Cost $/Q Average Cost Deadweight Loss Marg. Cost Demand MR Quantity Break Even Efficient

29. Natural Monopoly DilemmaNo Deadweight Loss and Single Price (P=4) where Price (Demand) = Marginal cost $/Q Average Cost Financial Loss Marg. Cost Demand MR Quantity Profit Max Break Even Efficient

30. Natural Monopoly DilemmaEfficient Output and Two Prices (P = 6 and P = 4) $/Q Revenue from first 6 Customers Average Cost Revenue from last 2 Customers Marg. Cost Demand MR Quantity Break Even Efficient

31. MONOPOLISTIC COMPETITION • Monopolistic Competition: • product differentiation (like monopoly) and a downward sloping demand curve • easy entry and exit (like pure competition) if excess profits occur • 1. In equilibrium, zero profits but excess capacity 2. In equilibrium, the slope of the average cost curve equals the the slope of the demand curve. (Price = average cost)

32. Monopolistic Competition Original Profits (10-7.33)(3)=8 Price Average Cost Marginal Cost Original Demand Q Original Marginal Revenue

33. Monopolistic Competition Original Profits (10-7.33)(3)=8 Price Average Cost Marginal Cost Equilibrium Demand Original Demand Q Original Marginal Revenue

34. Monopolistic CompetitionEquilibrium Price Average Cost Marginal Cost Equilibrium Demand Q

35. Monopolistic Competition Algebra P = 16-2Q and TC = 10 + 4 Q, AC=(10/Q) +4 With profits, entry of firms and expansion of output. Increased output lowers price. In equilibrium, demand curve shifts to the point of no excess profits after new entry. slope of demand curve = slope of Ave Cost curve dP/dQ = -2 = dAC/dQ = -10/Q2 or, solving for Q, Q = (10/2)0.5 = 2.236 and P = AC = 10/2.236 + 4 = $8.47 Profits = 0

36. OLIGOPOLY • Oligopoly- competition among few firms • Recognizing firm interdependence. If one oligopolist changes its output or price, • it expects others to change their outputs or prices in response • the price or quantity an oligopolist sets depends upon what each thinks other firms will do. • Choosing a Strategy • Price and output decisions can be made • sequentially • simultaneously • Nash Equilibrium • Each firm will do its best given its competitor’s actions • Natural to assume that competitors will also do their best given what their competitors (we) are doing 4. We consider a two-firm oligopoly called a Duopoly

37. Simultaneous choices • When firms make price and output choices but • don't know the choices of the other firms, they guess. • The choices are simultaneously determined. • There are two possibilities: • The firms simultaneously • choose prices (Bertrand model) • choose quantities (Cournot model)

38. Two Other forms of interaction • Two other forms of interaction which we will examine are: • Cartel : firms agree to set prices and quantities that maximize the sum of their profits. • Kinked Demand Curve • Each other firm reactsto a price decrease of a first firm by decreasing its own price so as to maintain its market share. • demand is very inelastic for price decreases of the first firm because other firms price decreases prevent the first firm to gain market share or much added demand • Each other firm does not react to price increases of the first firm. Others don’t raise their price. • demand is very price elastic for the first firm because it looses share to the firms not raising their price

39. 3. Example 1: Duopoly with differentiated products. • Firm 1: P1 = 24 - 3 Q1 - Q2, TC = 5 + 8 Q1 • Firm 2: P2 = 36 - 4 Q2 - 2 Q1, TC = 5 + 4 Q2 • The profit functions for firm 1 and firm 2 depend upon the output levels of both firms. • p1= P1Q1 - TC1 = (24 - 3Q1 - Q2)Q1 - 5 - 8 Q1 • p2 = P2Q2 - TC2 = (36 - 4Q2 - 2Q1)Q2 - 5 - 4 Q2.

40. 4. Collusion or Cartel: each firm sets its output to maximize total industry profits • pI = p1 + p2= P1Q1 - TC1+ P2Q2 - TC2 • pI= (24 - 3Q1 - Q2)Q1 - 5 - 8 Q1+ (36 - 4Q2 - 2Q1)Q2 - 5 - 4 Q2 • Taking the partial derivatives with respect to Q1 and Q2: ¶pI/¶Q1 = (24 - 6 Q1 - Q2) - 8- 2Q2 = 0 or • Q1 = 16/6 - 1/2 Q2 • ¶pI/¶Q2 = (36 - 8 Q2 - 2 Q1) - 4- Q1 = 0 or • Q2 = 4 - 3/8 Q1 • Q1 = .82, p1 = 3.077 • Q2 = 3.69, p2 = 52.564 pI = 55.64

41. Cartel Q1 Firm 2’s reaction curve given Q1 Firm 1’s reaction curve given Q2 .82 3.69 Q2

42. Cournot • 5. Each firm maximizes its own profits under the assumption that the other firm takes its output as given • p1= P1Q1 - TC1 = (24 - 3Q1 - Q2)Q1 - 5 - 8 Q1 • p2 = P2Q2 - TC2 = (36 - 4Q2 - 2Q1)Q2 - 5 - 4 Q2 • ¶p1/¶Q1 = 0 = (24 - 6Q1 - Q2) - 8 = 0 Q1 = 8/3 - 1/6 Q2 Reaction • ¶p2/¶Q2 = 0 = (36 - 8Q2 - 2Q1) - 4 = 0 Q2 = 4 - 1/4 Q1 Curves • Q1= 8/3-(1/6)[4-1/4 Q1] Q1 = 2.09 p1 = 8.06 • = 2 + (1/24) Q1 Q2 = 3.48 p2 = 43.37 • = (24/23)2 = 2.09 pI = 51.43

43. 5. Prisoner's Dilemma: Firm 2 acting as a Cournot Stackelberg Firm 1 Cournotp1 = 98 p1 = 55.125 acting p2 = 98 p2 = 110.25 _____________________________________________ as a Stackelbergp1 = 110.25 p1 = 70.56 p2 = 55.125 p2 = 70.56

44. 6. Tit-for Tat Strategy for repeated games a. cooperate on the first round b. If opponent cooperate on previous round, cooperate if opponent defects on previous round, defect (Do what your opponent did on last round)

45. Kinked Demand Curve • Price rigidity through behavioral assumptions. • a. Firm 2 will not raise its price if Firm 1 raises its price price increases will loses significant market share • b. Firm 2 will lower its price to maintain its market share if Firm 1 decides to lower its price. • price decreases won’t gain much share

46. Example • 1. Currently we have P1 = 200 Q1 = 1,000,000 P1 = 300 - .0001 Q1and • MR1 = 300 - .0002 Q1for price increases. P1 = 500 - .0003 Q1and • MR1 = 500 - .0006 Q1for price decreases

47. Kinked Demand Curve Price of Firm 1 Quantity of firm 1

48. Suppose Marginal Cost is currently $50 per unit. • If Marginal Cost rises to $75 per unit, the price stays at $200 • If Marginal Cost falls to $25 per unit, the price stays at $200 • If Marginal Cost rises to $125, ???

49. Price Leadership • Price Leader sets its price to maximize its profits knowing that following firms a. accept Leader’s price and b. maximize their own profits given that price. • 1. Assume a homogeneous product: P = PL = PS (all firms charge the same price) and • QL + QS = Q (ind. quan.= leader quan.+ follow. quan.) • Industry demand Q = 200 -.1 P • Leader's Cost Function TCL = 1000 + 50 QL • Aggregate (horizontal summation) cost function of following firms: • TCs = 100 Qs + 20 Qs2 MCs= 100 + 40 Qs

50. 2. Following firms act as price takers (maximize their profits by setting their price to their marginal costs). • This gives us the supply curve of the following firms: P = MCs = 100 + 40 Qs • or, solving for Q, the supply curve of the following firms is • Qs = -2.5 + .025 P