Chapter 6 Shahnaz Abdullah 1 Market Structure We

Chapter 6 • Shahnaz Abdullah 1

Market Structure • We will discuss 4 market structure MONOPOLY 2

Competition and Entry • Competition – Forms of competition • Lower prices because of economies of scale • Best service • Innovative products – Intention: to earn a positive economic profit – If others can do the same thing - economic profit will be driven to zero 3

Competition and Entry • Benefits of competition – Consumers - goods and services • Lowest possible prices – Resources - used in their highest-valued activities – Society • Goods and services for consumers • Lowest possible cost • Efficient resource allocation 4

Dolls • Toys available for girls – Barbie – American Girls by Pleasant Company • Collection of historical dolls • 4 million of them sold in the past 11 years • Clothes, accessories, furniture, craft kits, and even matching clothes in real-girl sizes – New competitors - distinct twist 5

The American Girls Phenomenon • Competitors – Global Friends – Just Pretend – My Twinn dolls – Little Women dolls – Storybook Heirlooms – Magic Attic club 6

Market Structures Competition Monopolistic Competition many firms/buyers free entry/exit product homogeneity perfect information Farmer’s market • Oligopoly Monopoly Many smaller firms small # of bigger firms 1 supplier free entry/exit difficult to enter barriers to entry differentiated products same or different Q one product perfect info imperfect info fast food, clothes, steel, cars, cell phones, cereals, aspirin, colas local cable local utility Microsoft •

The American Girls Phenomenon • Differentiation – Different sizes • Their expensive clothes won’t fit on dolls from rival collections • Doll companies – Zero economic profit – Additional companies are not entering the market 8

Competition and Entry • Creative destruction – Old, inefficient, or obsolete goods, services, and resources – Are driven out of business – As new or efficient technologies and goods and services arise – Competition is the engine of creative destruction – Takes time and it can be difficult 9

Competition and Entry • Commodity – Goods perceived to be identical – No matter who supplies them • Perfect competition – Market structure – Large number of sellers of a commodity – No one firm has an effect on the market – Price takers • Same selling price – the opportunity cost 10

Competition and Entry • Differentiated – Good, service, or firm that consumers believe to be somewhat unique • Monopolistic competition – Market structure – Large number of firms – Easy entry – Differentiated products – Higher price 11

Competition and Entry • Monopoly – Market structure – Only one firm – Entry by other firms is not possible – Higher price 12

EXAMPLE: Cell Phone Duopoly in Smalltown P Q $0 140 5 130 650 1, 300 – 650 10 120 1, 200 0 15 110 1, 650 1, 100 550 20 100 2, 000 1, 000 25 90 2, 250 900 1, 350 30 80 2, 400 800 1, 600 35 70 2, 450 700 1, 750 40 60 2, 400 600 1, 800 45 50 2, 250 500 1, 750 OLIGOPOLY Revenue Cost Profit $0 $1, 400 – 1, 400 Competitive outcome: • P = MC = $10 • Q = 120 • Profit = $0 Monopoly outcome: • P = $40 • Q = 60 • Profit = $1, 800 13

Table 6. 1 Summary of Competition 14

Competition and Entry • Monopoly – Downward-sloping demand – As the price decreases, the quantity sold increases – Maximize profit • Price and quantity where MR=MC 15

Competition and Entry • Firm in Monopolistic competition – Downward-sloping demand • Flatter than for monopoly • More elastic – Maximize profit • Price and quantity where MR=MC • Lower price than in Monopoly • Higher quantity 16

Competition and Entry • Firm in Perfect competition – Horizontal demand • Price takers – sell at the market equilibrium price • P = MC • Perfectly elastic – Maximize profit • Quantity where MR=MC • Lower price than in Monopolistic copetition • Higher quantity 17

Figure 6. 1 The Coffee Shop The coffee shop creates a unique experience and determines the profitmaximizing price to be $1. 50 per cup of coffee. This exceeds total costs of $. 80 per cup, creating an economic profit of $. 70 per cup. As rivals enter and compete with the initial coffee shop, the price is bid down. The shop lowers the price until it is receiving its opportunity costs, $. 80 per cup, plus the value consumers place on its special attribute, $. 10 per cup. 18

Figure 6. 1 The Coffee Shop; Figure 6. 1(c) As the value of the special attribute is eroded, the product becomes a commodity. The coffee and experience offered by the initial shop are not valued any differently than the coffee and experience offered by a different shop. The price is driven down to just equal opportunity costs. Economic profit is zero. 19

Table 6. 2 Summary of Demand Curves and Competition 20

1. Creative destruction is a term given to the process of competition whereby old, inefficient, or obsolete goods, services, and resources are driven out of business as new or more efficient technologies and goods and services arise. 2. When entry is easy or free and competitors can offer an identical product, no firm can earn positive economic profit. 3. A commodity is a product that is identical no matter who sells it. A cup of coffee from one seller is no different in the consumer’s mind than a cup from a different seller. This type of market is called perfect competition. 21

1. When a firm can create a special attribute that other firms cannot copy identically, the firm can earn positive economic profits as long as consumers place a value on that special attribute. Economists refer to this situation as monopolistic competition. A monopoly is a sole supplier—that is, the only supplier of a good or service. If a firm has a monopoly, the firm can earn positive economic profit as long as the monopoly prohibits entry. 22

1. The market demand curve for a good or service will slope downward, illustrating the idea that as the price of the good or service is lowered, the quantity demanded will rise. The fewer substitutes there are, the more price inelastic demand is. As more and more competitors enter the business, consumers have more and more choices. As a result, demand for any single seller’s good or service will become more price elastic, and the demand curve will become flatter and flatter. In perfect competition, the single firm’s demand curve is horizontal. 23

1. The demand curve for the seller of a commodity —that is, the demand for a good or service offered by a single seller in a perfectly competitive market—will be perfectly elastic or horizontal. 24

Creating Barriers to Entry • Barriers to entry – Restriction on the ability of rivals to open new firms • In competition with the incumbent firm – The incumbent can earn positive economic profit for a long period of time 25

Why Monopolies Arise The main cause of monopolies is barriers to entry – other firms cannot enter the market. Three sources of barriers to entry: 1. A single firm owns a key resource. E. g. , De. Beers owns most of the world’s diamond mines 2. The govt gives a single firm the exclusive right to produce the good. MONOPOLY E. g. , patents, copyright laws 26

15. 1 MONOPOLY AND HOW IT ARISE – Natural Barrier to Entry – A natural monopoly exists when the technology for producing a good or service enables one firm to meet the entire market demand at a lower price than two or more firms could. – One electric power distributor can meet the market demand for electricity at a lower cost than two or more firms could.

Creating Barriers to Entry • Brand name - barrier to entry – Signal of quality or reliability • Sunk cost – Cost that cannot be recouped • High sunk cost - barrier to entry – Tell a potential new firm • That it has to throw just as much money away on similar sunk expenditures • If it is going to compete 28

Creating Barriers to Entry • Unique resources – barrier to entry – Owners of the only mine that produced desiccant clay – De. Beers – 80% of the diamonds in the world • When the Russian economy was tightly controlled by the government – Microsoft – stock of top scientists 29

Creating Barriers to Entry • Economies of scale – Decreases in per-unit costs when all resources are increased • Size of firm relative to the market – barrier to entry – Large firm - High startup costs – Economies of scale • Allows more specialization • Larger machines are more efficient 30

Creating Barriers to Entry • Diseconomies of scale – Increases in per-unit costs when all resources are increased • Larger firms - not automatically improve efficiency – Specialization – may require additional specialized managers • More paperwork, more meetings – Diseconomies of scale 31

Creating Barriers to Entry • Most industries – Experience both economies and diseconomies of scale • Economies of scale for smaller sizes and diseconomies of scale for larger sizes – For a very large demand • The smaller firm has the advantage – For a small demand • The larger firm has the advantage 32

1. A firm will attempt to slow down the onslaught of competitors when the firm earns a positive economic profit. Anything that can restrict entry is called a barrier to entry. 2. A firm will be able to earn a positive economic profit if it can create a special attribute that other firms cannot easily mimic and that consumers value. Brand name is the term given to such special attributes. 3. A sunk cost is a cost that cannot be recouped. If the incumbent firm can impose sunk costs as a condition to entry, firms may be inhibited from entering. 33

1. If a firm has a unique resource needed in the operation of the firm, then other firms may not be able to enter the business until a substitute can be found. 2. Economic profit induces entry and new competition, which drives economic profit to zero unless there are barriers. 3. The long run is a period just long enough so that all resources are variable; there are no fixed resources. 4. Economies of scale occur when the per-unit costs decline as all resources (the size of the firm) increase in the long run. 34

1. If an industry is characterized by economies of scale, then the large firm can produce at lower per-unit costs than the small firm can. To enter this industry, a firm must be large. 2. Whether economies of scale give a cost advantage to a large firm depends on the extent of the market. If demand is sufficiently large so that a large firm can realize economies of scale, then firm size is a distinct advantage. 3. Diseconomies of scale occur when, as the size of the firm increases, the per-unit costs rise. 35

Number of Firms: Oligopoly • Oligopoly – market structure – Few firms; Difficult entry – Either standardized or differentiated products – Interdependence – May result from • Government intervention – Limited competition • Cost conditions - economies of scale – Cutthroat competition 36

Number of Firms: Oligopoly • Interdependence – A firm does not decide what to do • Without considering what the other firms in the industry will do – Actions of one firm can dramatically affect the others • Forms of oligopoly • One dominant firm coexisting with many smaller firms • Group of giant firms dominate the industry 37

Number of Firms: Oligopoly • Cutthroat competition – Competition through innovation, patents, and other means • No barriers to entry – Profit will be competed away • Barriers to entry – Earn economic profit 38

Number of Firms: Oligopoly • Game theory – Description of oligopolistic behavior – As a series of strategic moves and countermoves • Dominant strategy – Strategy that produces better results no matter what strategy the opposing firm follows 39

Game Theory • Game theory helps us understand oligopoly and other situations where “players” interact and behave strategically. • Dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players • Prisoners’ dilemma: a “game” between two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial OLIGOPOLY 40

Figure 6. 2 Dilemma: Dominant Strategy Game Figure 6. 2 illustrates the dominant strategy game. The dominant strategy for firm A is to advertise. No matter what firm B does, firm A is better off advertising. If firm B does not advertise, firm A earns 80 not advertising and 100 advertising. If firm B does advertise, firm A earns 40 not advertising and 70 advertising. Similarly, firm B is better off advertising no matter what firm A does. Both A and B have dominant strategies— advertise. 41

• Is Advertising a Prisoner’s Dilemma for Coca-Cola and Pepsi? • Use game theory to analyze the strategies of oligopolistic firms. • Given that Coca-Cola is advertising, Pepsi’s best strategy is to advertise. Therefore, advertising is the optimal decision for both firms, given the decision by the other firm.

Prisoners’ Dilemma Example • Outcome: • Both would have been better off if they do not advertise. • But even if they had agreed before, the logic of self-interest takes over and leads them to advertise. 43

The Prisoners’ Dilemma • Prisoner’s dilemma – Prisoners’ dilemma: a “game” between two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial – A one time interaction – No communication between parties is allowed • Dominant strategy for both prisoners • Both A and B have dominant strategies— advertise. 44

Number of Firms: Oligopoly • Nash equilibria – No player can be made better off by changing unilaterally – Occurs where there is not a dominant strategy • Convention – Institution procedure increasing efficiency 45

The result is what is known in game theory as a Nash Equilibrium; • i. e. , an equilibrium in which each player takes the action that is best • for him or her given the actions taken by the other player. • This is named after the famous mathematician and Nobel prize Laureate John Nash. • Because the individuals do not take into account the impact of theiractions on the other players, this is known as a non cooperative Equilibrium. MONOPOLY 46

Number of Firms: Oligopoly • Leadership oligopoly – One firm - the leader in changes in price or advertising activities • Rivals follow that leader – Enables all firms to know exactly what their rivals will do – Avoids the prisoners’ dilemma • Price-leadership oligopoly – Leadership oligopoly – changes in price 47

Number of Firms: Oligopoly • Cartel – Organization of independent firms – Purpose • To control and limit production • To maintain or increase prices and profits – Organization of independent producers • Dictates the quantities produced by each member of the organization – Illegal in the U. S. 48

Number of Firms: Oligopoly • Problems with cartels – Firms have an incentive to cheat on the agreement – Difficult to maintain different production quotas – The incentive to cheat – leads to the collapse of the cartel 49

Number of Firms: Oligopoly • Collusion – Practice by rivals to limit competition • Agree not to lower prices • Work together to limit entry by others – Act as a monopoly: higher profits – To be effective: each firm has to offer less for sale than each would have in competition – It is illegal to collude in the U. S. 50

OPEC and the world oil market Case Study • Organization of Petroleum Exporting Countries (OPEC) – Formed in 1960: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela – By 1973: Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon – Control about three-fourths of the world’s oil reserves – Tries to raise the price of its product • Coordinated reduction in quantity produced 51

OPEC and the world oil market • OPEC – Tries to set production levels for each of the member countries • Problem – The countries - want to maintain a high price of oil – Each member of the cartel • Tempted to increase its production • Get a larger share of the total profit • Cheat on agreement 52

ACTIVE LEARNING 3 Answers Nash equilibrium: both firms cut fares • American Airlines • Cut fares • $200 million • $400 million • Cut fares • United Airlines • Don’t cut fares • $800 million • $400 million • $600 million • $800 million • Don’t cut fares • $200 million • $600 million 53

1. Oligopoly is a market structure in which there are so few firms that each must take into account what the others do, entry is difficult, and either undifferentiated or differentiated products are produced. 2. An oligopoly may come into being because government allows only a few firms to control or dominate an industry, or it may arise as a result of economies of scale. 3. Interdependence and strategic behavior characterize oligopoly. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 54

1. The prisoners’ dilemma shows how firm interactions can result in an outcome that is not the best for the competing firms. 2. Oligopolistic firms have incentives to cooperate. In a price-leadership oligopoly, one firm determines the price and quantity, knowing that all other firms will follow suit. The price leader is usually the dominant firm in the industry. 3. Collusion, or making a secret cooperative agreement, is illegal in the United States. Cartels, also illegal in the United States, rest on explicit cooperation achieved through formal agreement. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 55

1. The incentive for cartel members to cheat typically leads to the collapse of the cartel. To minimize cheating, one member must police the others. 2. Facilitating practices implicitly encourage cooperation in an industry. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 56