Principles of Economics

Principles of Economics Session 8

Topics To Be Covered • Imperfect Competition & Market Power • Characteristics of Oligopoly • Collusion vs. Competition • Kinked Demand Curve Model • Game Theory • Characteristics of Monopolistic Competition

Topics To Be Covered • Profits and Losses of the Monopolistic Firm • Long-Run Equilibrium of Monopolistic Competitive Market • Monopolistic vs. Perfect Competition • Comparison and Contrast betweenFour Types of Market Structure • Standards Wars

Many firms One firm Few firms Perfect Competition Monopolistic Competition Oligopoly Monopoly • Tap water • Cable TV • Automobile • Crude oil • Clothing • Furniture • Wheat • Rice Four Types of Market Structure Number of Firms Type of Products Differentiated products Identical products

Imperfect Competition Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly.

Imperfect Competition Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.

Types of Imperfectly Competitive Markets • Oligopoly • Only a few sellers, each offering a similar or identical product to the others. • Monopolistic Competition • Many firms selling products that are similar but not identical.

Market Power Market power is thedegree of control that a firm or group of firms has over the price and production decisions in an industry. The monopolistic firm has a high degree of market power while perfectly competitive firms have no market power. Measures of market power: concentration ratio, Lerner’s index, Herfindahl-Hirschman index

Concentration Ratio Concentration ratio is the percentage of an industry’s total output accounted for by the largest firms. A typical measure is the four-firm concentration ratio, which is the fraction of output accounted for by the four largest firms.

Costs, Revenueand Price MC E P P-MC ATC MC P D= AR MR 0 Quantity QMAX Lerner’s Index • Lerner’s index is an efficient way to measure the market power. L = (P - MC)/P

Herfindahl-Hirschman Index HHI is calculated by squaring the market share of each firm competing in a market and then summing the resulting numbers. • HHI ranges from a minimum of close to 0 to a maximum of 10,000.

Herfindahl-Hirschman Index If HHI ＜ 1,000, the industry is considered as competitive. If 1,000 ≤ HHI ＜1,800, the industry is considered as moderately concentrated. If HHI ≥ 1,800, the industry is considered as highly concentrated. As a general rule, mergers that increase the HHI by more than 100 points in concentrated markets raise antitrust concerns.

Herfindahl-Hirschman Index If there were only one firm in an industry, that firm would have 100% market share and the HHI would be equal to 10,000 (1002). If there were thousands of firms competing, each would have a nearly 0% market share and the HHI would be close to zero, indicating nearly perfect competition.

Characteristics of an Oligopoly Market • Small number of suppliers • Similar or identical products • Barrier to entry • Interdependent firms

Small Number of Suppliers • As small as they might cooperate or collude in such strategies as pricing. • Examples: automobiles, steel, computers

Barriers to Entry • Scale economies • Patents • Technology • Name recognition

Interdependence • In perfect competition, the producers do not have to consider a rival’s response when choosing output and price. • In oligopoly the producers must consider the response of competitors when choosing output and price.

Collusive Oligopoly • Oligigolopists can collude to form a cartel in which they work together to raise prices and restrict output. • Collusive oligopolists at large can profit as a monopoly does.

E Collusive B price profit Average total cost D C Collusive Quantity Collusive Oligopoly P MC ATC D MR Q 0

Obstacles ofEffective Collusion • In the vast majority of countries, collusion is illegal. • Members of the cartel are tempted to cheat on the agreement. • With the development of international trade, many oligopolists face intense competition from foreign firms as well as domestic companies.

The Kinked Demand Curve Model • The kinked demand curve model describes a situation in which a firm assumes that other firms will match its price reductions but will not follow price increases. • The optimal strategy in such a situation is frequently to leave the price at the current level and to rely on nonprice competition rather than price competition. • The model explains the price rigidity in the oligopolistic industry.

If the producer raises price the competitors will not and the demand will be relatively elastic. If the producer lowers price the competitors will follow and the demand will be relatively inelastic. The Kinked Demand Curve Model P Q 0

P* MC” MC’ D MC Q* MR The Kinked Demand Curve So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. P Q 0

The Equilibrium for an Oligopoly A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

How the Size of an Oligopoly Affects the Market Outcome As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

Game Theory: Competition vs. Collusion Game theory is the study of how people behave in strategic situations. Strategic situations are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

Game Theory: Competition vs. Collusion • Because the number of firms in an oligopolistic market is small, each firm must act strategically. • Each firm knows that its profit depends not only on how much it produced but also on how much the other firms produce. • An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face.

The Prisoners’ Dilemma • Two prisoners have been accused of collaborating in a crime. • They are in separate jail cells and cannot communicate. • Each has been asked to confess to the crime.

The Prisoners’ Dilemma • If they both confess, they both will be sentenced to 5-year imprisonment. • If neither confesses, they both will be sentenced to 2-year imprisonment. • If one confesses and the other does not, the one who confesses will be sentenced to 1-year imprisonment while the other will be sentenced to 10-year imprisonment.

-5 -10 -1 -5 -1 -2 -2 -10 Peter’s Decision Confess Remain Silent The Prisoners’ Dilemma A B Confess Bob’s Decision C D Remain Silent

The Dominant Strategy The dominant strategy is a situation where one player has a best strategy no matter what strategy the other player follows.

The Dominant Equilibrium When all players have a dominant strategy, we say that the outcome is a dominant equilibrium.

$10 -$100 $10 -$10 -$10 -$50 -$50 -$100 Peter’s Price Normal Price Price War The Dominant Equilibrium A B Normal Price Bob’s Price C D Price War

The Dominant Equilibrium • Both Peter and Bob have a dominant strategy, for the best decision for them is to choose the normal price. • There is a dominant equilibrium for them in cell A.

P Q Collusion vs. Competition P MC ATC D MR Q

The Nash Equilibrium A Nash equilibrium is one in which no player can improve his or her payoff given the other player’s strategy.

$200 $150 $100 -$20 -$30 $10 $10 $150 Peter’s Price High Price Normal Price The Nash Equilibrium A B High Price Bob’s Price C D Normal War

The Nash Equilibrium • Bob has a dominant strategy, while Peter does not. However, they can reach a Nash equilibrium in cell D. Given Bob’s strategy to charge a normal price, Peter can can do no better than to charge a normal price. • A dominant equilibrium is necessarily a Nash equilibrium, but not vice versa.

$0 -$100 $0 $800 $600 $300 $250 -$50 Peter’s Strategy Competitive Output Low Output The Invisible-Hand Game A B CompetitiveOutput NI＝$4400 NI＝$5000 Bob’s Strategy C D Low Output NI＝$4500 NI＝$4000

Collusion vs. Competition Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits. However, competition is more beneficial to society and the invisible hand can make the economy more efficient.

$30 $20 $30 $50 $50 $40 $40 $20 Peter’s Decision Don’t Advertise Advertise The Advertising Game A B Advertise Bob’s Decision C D Don’t Advertise

$100 $120 $100 -$30 -$30 $100 $100 $120 Peter Steel High Pollution Low Pollution The Pollution Game A B Low Pollution Bob Steel C D High Pollution

$50 $300 $50 $50 $50 $300 $0 $200 Winner Work inStandard Industry Work in Winner-Take-All Industry The Winner-Take-All Game A B Work in Standard Industry NI＝$350 NI＝$100 Runner-Up C D Work in Winner-Take-All Industry NI＝$250 NI＝$300

Why People Sometimes Cooperate Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain.

Public Policy Toward Oligopolies Cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too low and prices that are too high.

Monopolistic Competition Markets of monopolistic competition are those that have features of both competition and monopoly. It is the most common type of market structure.

Characteristics of Monopolistic Competition • Many sellers • Differentiated products • Free entry and exit

Many Sellers There are many firms competing for the same group of customers. Examples: CDs, movies, restaurants, furniture, etc.

Differentiated Products • Each firm produces a product that is at least slightly different from those of other firms. • Rather than being a price taker, the firm can change its output and consequently influence the price of the product.

Free Entry or Exit • Firms can enter or exit the market without restriction. • It is the striking difference from the monopolistic market which has high barriers to entry and exit.

Principles of Economics