Lecture 3: Imperfectly Competitive Markets

1. Lecture 3: Imperfectly Competitive Markets Required Text: Chapter 2Market Models

2. Monopoly • When there many buyer of a good with no close substitutes but only one seller, the market is called a monopoly. • Bt cotton (of Monsanto) • Windows (of Microsoft Corporation) • The extent of monopoly hinges crucially on whether there are close substitutes available • KFC sells a unique type of chicken with 11 herbs and spices • Still KFC is not a monopoly, because there are many other restaurants selling similar fried chicken • Due to competitors, KFC cannot set any price it wants

3. Monopoly • A monopolist faces a downward sloping demand curve (i.e., the market demand) • Since a monopolist is the only seller of the good, it can set whatever price it wants – price setter • The monopolist faces a trade-off though – the higher the price it charges, the less consumers will buy • The monopolist sets the price that maximizes its profits • Profit maximizing condition: MR = MC • A monopolist sells the quantity where MR and MC curves intersect • The monopolist sets a price corresponding to that optimal production point on the market demand curve

4. Monopoly Price and Output

5. Monopoly • A monopolist faces a downward sloping marginal revenue curve, which always lies underneath the demand curve. • Because, the monopolist has to lower the price to sell an additional unit of the good – lowers price to increase output • A Monopolist operates on the elastic portion of the demand curve • A monopolist do not have a supply curve, because there is no “going price.”

6. Sources of Monopoly Power • Natural monopoly • Industry where AC curve decreasing at the point where crosses market demand • Industry survives only if monopolized • Patents • Ex. photography • Resource monopolies • Single firm controls productive input • Legal barriers to entry

7. Natural Monopoly

8. Price Discrimination • Charging different prices for identical items • Ability to prevent resell of low-price units • First-degree Price Discrimination • Charging different customers different prices (as the customers are most willing to pay) for an identical good • Second-degree Price Discrimination • Charging same customer different prices for different unit of the same good • Third-degree Price Discrimination • Charging different prices for the same good in different markets

9. Third-degree Price Discrimination • Charging different prices in different markets • Groups of consumers identifiable • Different downward sloping demand curve • Producer profit • Production of goods where MR same in both markets and equal to MC • More elastic demand group receives lower price

10. Third-Degree Price Discrimination by a Monopolist in Two Markets

11. Two-Part Tariffs • Entry fee allows purchase of goods or services • Meaning of tariff • Customers are charged maximum willingness to pay • Measure consumer’s surplus • Charge competitive price as long as no difference in consumers • Charge low initial fee and high usage fee

12. Pricing Strategy with a Two-Part Tariff

13. Monopsony • When there many seller of a good with no close substitutes but only one buyer, the market is called a monopsony. • College athletes – NCAA • Even though college athletes have their choice of schools to attend, the NCAA limits the compensation they can receive. • In a sense al college athletes work for the NCAA, and the NCAA has complete control over the prices paid to the athletes. • A monopsonist is a consumer – it is theonly consumer. • It seeks to maximize its consumer surplus

14. Monopsony • A monopolist faces a upward sloping supply curve (i.e., the market supply) • Since a monopsonist is the only buyer of the good, it can set whatever price it wants – price setter • The monopsonist faces a trade-off though – the lower the price it pays, the less sellers will sell • The monopsonist sets the price that maximizes its profits • Profit maximizing condition: MV = ME • A monopsonist purchases the quantity where marginal expenditure (ME) and marginal value (MV) curves intersect • The monopsonist pays a price corresponding to that optimal consumption point on the market supply curve

15. Monopsony • A monopsonist’s marginal value or demand curve is downward sloping. • A monopsonist’s marginal expenditure curve is upward sloping, which always lies above the marginal cost (supply) curve. • Because, the monopsonist has to raise the price to purchase an additional unit of the good – increases price to increase consumption • A Monopolist operates on the elastic portion of the demand curve

16. Monopsony Equilibrium ME MC = Supply Curve P MV = Demand Curve Q

17. Monopolistic Competition(Differentiated Competition) • When a market consists of many firms, each competing to sell a different variety of a product or service, each variety being different in some way but a close substitute for one another, the market is called a monopolistic competition. • Hamburgers sold by McDonalds, Burger King, Wendy’s, etc. • Soda, candy, fast food, etc. • Each firm produces a differentiated good, which is not imitated perfectly by any other firm. However, other firms produces varieties that are close substitutes. • Since each firm sells a unique variety of a product, each firm is like a “small monopoly.” • Each firm can set any price for that variety – monopoly market power.

18. Monopolistic Competition(Differentiated Competition) • Like a monopoly, a monopolistic firm faces a downward sloping marginal revenue (MR) curve, that lies below the demand curve it faces, and maximizes its profits by producing where MR=MC. MC = Supply Curve (firm) P MV = Demand Curve (firm) MR (firm) Q

19. Monopolistic Competition(Differentiated Competition) • Since each firm produces a differentiated good, there is a single marginal value (demand) curve for each variety, and single marginal cost (supply) curve for each variety. • In a monopolistic competition, there is so much competition among the many sellers of a differentiated product that the price results often appear similar to those of a perfect competition. • Unlike a real monopoly there is free entry and exit of other firms that produce close substitutes. • Each time a new firm enters with its own variety, the demand curve for all other firms falls. • The greater the variety, the less each consumer is willing to pay for any single variety.

20. Monopolistic Competition(Differentiated Competition) • Each time a new firm enters with its own variety, the demand curve for all other firms falls – that is the market share of other firms falls. MC = Supply Curve (firm) P MV = Demand Curve (firm) MR (firm) Q

21. Monopolistic Competition(Differentiated Competition) • Whenever producer surplus per firm is greater than fixed costs, new firms will enter the market with new varieties, decreasing the demand curve facing all firms. • Similarly, when producer surplus per firm is less than fixed costs, some firms will begin to leave the market. • As firms enter and exit the market, they will eventually settle on an equilibrium where economic profits are zero. • At zero economic profits, each firm is making just as much money it could in their next best alternative. • Producer surplus per firm equals the fixed cost for the firm – firms are indifferent between producing or not.

22. Oligopoly • When there only a few sellers of a product or service and many buyers, the market is called an oligopoly. • There are only a few sellers of credit cards – Visa, MasterCard, Discover, and American Express. • Anheiser-Busch, Miller, and coors collectively sell 90% of all beers purchased in the US • The soda market is dominated by Coca-Cola and Pepsi • Five beef packing firms sell 80% of all beef processed in the US. • Oligopolies can exist for a number of reasons • Economies of scale – to produce a good at low per unit cost, you need to “get big.” • Limited demand for any one product – once the market is saturated by a few big firms, entering the market would not be profitable.

23. Oligopoly • The price that results from an oligopoly follows no simple formula – the reason is that oligopoly firms engage in strategic behavior. • When Pepsi increases its advertising, so does Coca-Cola. • Firms in an oligopoly have incentives to both collude and compete. • Tacit Collusion: Sometimes, without explicit planning oligopoly firms charge similar high prices, which are close to the monopoly price. • Unsolicited understanding that both will keep their prices high. • Neither reduces it’s price, because it is scared that the other firms will retaliate with a price reduction in turn – price war.

24. Oligopoly • Tacit collusion usually occurs through price leadership – where one firm announces a price and all other firms respond with similar price. • Price Warfare: Sometimes, oligopoly firms engage in price war that leads to low prices close to that of perfect competition. • Airline tickets – there are only a few airlines, but every airline struggles to avoid bankruptcy. • Soups in grocery stores are not expensive – there are only a few vendors. • Because of collusion or competition, price can be low or high in oligopolies. • Oligopoly price lies somewhere in between the monopoly and perfect competition prices.

25. Oligopsony • When there only a few buyers of a good or service and many sellers, the market is called an oligopsony. • There are thousands of cattle producers (ranches and feedlots) throughout the midwest, yet there are only few firms (beef packers) who purchase cattle. • These cattle buyers have the power to depress prices, if they collude with one another to keep price down – monopsony power. • However, the buyers also compete with one another for a limited supply of cattle raising the purchase price – price warfare – competition. • Since both elements of collusion and competition are present in oligopsony, price can be low or high. • Oligoposony price lies somewhere in between the perfect competition and monopsony prices.

26. Market Models Compared