AAEC 2305 Fundamentals of Ag Economics

1. AAEC 2305Fundamentals of Ag Economics Chapter 7 - continued

2. Firms in an Imperfect Market • Consider the following hypothetical case of a tractor division of a farm machinery manufacturer operating in an imperfectly competitive environment. • Assumptions of this example: • There are no competitors • The firm manufactures & sells 7100 to 9000 tractors per year at $44,000 to $52,000 per tractor

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5. (continued) • The equilibrium price per tractor is the price where MR and MC curves intersect (MR=MC) • Under perfect competition, the MR and AR curves where equal and represented by a horizontal line, which also depicted the price line • In Imperfect Competition, however, the MR and AR curves are two distinct curves (MR does not equal AR)

6. (continued) • Under Imperfect Competition, the AR curve depicts the demand curve. Additionally, the MR curve has a slope exactly twice the AR and Demand curves. • Furthermore, the MR curve intersects the horizonatl axis at exactly the same point as the AR curve. However, the MR curve intersects the horizontal axis at exactly the halfway point of the AR curve.

7. Determination of Output • As in perfect competition, the output of the imperfectly competitive firm is determined at the point where MR = MC • The price that the imperfectly competitive firm will charge, however, will be the price associated with the market demand curve for the profit maximizing quantity.

8. (continued) • To determine profitability, the firm will need to compare TR and TC or AR and ATC.

9. Imperfect Competition Among Sellers • There are 3 categories of imperfect competition among sellers (refer to Table 7.1, page 161. • 1) Monopolistic Competition • 2) Oligopoly • 3) Monopoly • Remember we are going to use Perfect Competition as the baseline for comparisons.

10. Monopolistic Competition • Monopolistic Competition differs from Perfect Competition in the following ways: • 1) Differentiated Products (main difference from pure competition. • Real differences in products • Perception of differences in Consumers Minds • Competition among firms exist on attributes other than prices

11. (continued) • 2) Many firms, but fewer than under perfect competition • Food processing & marketing firms • 3) Limited control over prices • A firm cannot increase prices significantly without losing customers to competitors.

12. (continued) • 4) Limited or restricted entry • Entry is more difficult than in a perfectly competitive market • Firms are fairly large, and capital requirements are substantial • Advertising dollars alone can create a barrier to entry • Emphasis on brand names associated with higher quality

13. Oligopolies • Oligopoly means “few sellers” • The most distinguishing characteristic is their interdependence in pricing and marketing policies. • Among oligopolistic industries are: • Major farm machinery companies • Farm chemical companies • Major meat packers

14. (continued) • Oligopolistic industries can result from: • More extreme product differentiation • Higher entry costs • Greater dependence on costly & long-term research & development efforts • Easier access to major financial markets • Aggressive merger & acquisition strategies

15. (continued) • Characteristics of Oligopolies are: • 1) Few Sellers - (ex. auto manufactures, oil industries, etc.) • 2) Some control over prices • Control over prices is limited due to interdependence with other firms • Have sticky prices to try to avoid price wars • Farmers complain that prices for their crops do not increase even when consumer prices rise.

16. (continued) • Farmer complain that prices for machinery and farm chemicals are inflexible • Consumers complain that retail prices remain high even when farm prices fall • Oligopolies provide benefits that perfectly competitive markets do not: • International competitiveness • Access to funds for research and development • High barriers to entry

17. Pricing behavior in Oligopoly • Mutual interdependence in oligopoly requires strategic behavior & interactions • Strategic behavior is actions by firms trying to plan for and react to the actions of other firms • Strategic decision-making is called Game Theory. • Example - Prisoners Dilemma:

18. Prisoners Dilemma • A crime is committed, and two suspects are apprehended and questioned by the police • The police do not have enough evidence to convict the suspects of a major crime, unless one of them confesses. • The police separate the suspects and make each one an offer that each one is aware of.

19. (continued) • The offer is: • If one suspect confesses to the crime and turns state’s witness, the one who confesses receives only a 2-year sentence, while the other who does not confess will get 12 years. • If both prisoners confess, each receives a 6-year sentence. • If neither confesses, both will receive a 1-year sentence.

20. (continued) • Refer to class discussions on the possible outcomes. • This process is called the minimax strategy, meaning the players want to minimize their maximum losses • If both suspects had not confessed, each would have been sentenced to 1 year, but the temptation is too high.

21. (continued) • This same scenario exists for oligopolistic firms.

22. (continued) • Now consider the following example for two hypothetical meat packing firms. • The two firms are trying to set prices, but realize their decisions along with the decision of their competitor affects their profitability.

23. (continued) • The choice is: • If one firm charges a lower price and the other firm charges a higher price, the firm that charges the lower price will receive$125,000 profit and the firm charging the higher price will receive $25,000. • If both charge a high price, both receive $100,000 profit. • If both charge a low price, both receive $50,000 profit.

24. (continued) • Clearly, the choices of each firm make a significant difference. • The point of the example is that the firms must anticipate the reaction of other firms in their industry to their pricing strategies.

25. (continued) • If one firm raises the price of its product, other firms may not raise prices to the same extent. • As a result the firm raising its prices may lose market share. • But if the firm lowers its price, other firms may likely lower their prices as well to avoid losing market share.

26. Kinked Demand Curve • The result is that each firm in an oligopolistic industry faces a kinked demand curve. • The kink in the demand curve is at the current price and quantity. • Above the kink, the demand curve tends to be more elastic. • Below the kink, the demand curve tends to be more inelastic.

27. 4 Types of Pricing Behaviors in Oligopolistic Markets • 1) Noncollusive Oligopoly • A firm may increase prices if it determines that its product is good enough, or the loyalty of the customers is strong enough, for it to do so without losing market share. • Alternatively, a firm may cut prices in an attempt to drive rivals out of the market or to weaken them enough to make them good targets for takeover. • Ex. Airlines, farm machinery, pesticides, etc.

28. (continued) • 2) Collusive Oligopoly- • If all firms in an industry reach an explicit or tacit agreement to fix prices. • Firms then compete on the basis of non-price factors such as service or advertising. • Thus, as in our packer example, there is a significant incentive to collude & raise prices. • Problems - incentive to cheat on the agreement.

29. (continued) • 3) Price Leadership - • In some industries, there is a recognized price leader. • Additionally, in some cases, there may be little explanation why a firm is the price leader. • 4) Cost-Plus Pricing- • It is common practice in some industries, especially selling unique products to the government, to sell products at cost plus a given percentage mark-up

30. Monopoly • Strictly speaking, a pure monopoly - a one firm industry - is rare. • Monopolies may arise because sometimes because it is the most efficient way to organize production and marketing activities. • However, instead of breaking up monopolies in the US, it has been common policy to regulate them.

31. Basic Characteristics of Monopolies • 1) Single seller • 2) Unique Product • i.e. there are no close substitutes • 3) Ability to Set Prices • Monopolist is a price maker, although in some cases they may be regulated by the gov’t. • Discriminating monopolists charge different prices to different classes of consumers

32. (continued) • 4) Barriers to Entry • A monopoly must have an economic, legal or technical barrier to entry to other firms. • The gov’t has established many agencies to protect consumers from the adverse consequences of oligopolies & monopolies • Interstate Commerce Commission - regulates transportation

33. (continued) • Federal Communication Commission - regulates telephone rates, tv, radio, etc. • State & Local Power Commissions - regulate local utilities • U.S. Sherman (antitrust) Act of 1890 and Clayton Act of 1914 • First of several acts with goal of preventing collusive pricing and restrictive trade practices of oligopolies

34. (continued) • However, these laws and more recent laws have been enforced to a varying extent by successive presidential administrations - depending on the philosophy of each administration.