CHAPTER 7 MARKET STRUCTURES SWS 2006 2 SWS

CHAPTER 7: MARKET STRUCTURES

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Quick discussion Why is competition in a market for a good so important? – What are some of the benefits of competition in a market for a good? (example: phones)

Market Structure Simulation Each of you have been grouped into a type of market structure – – Perfect competition (cannot talk to each other) Monopolistic competition (cannot talk) Oligopoly (can discuss price, but can act on your own) Monopoly (On your own) 3 rounds – I buy one piece of candy from each group, each round. My motivation is to get the best deal. Your motivation is to make a profit (sell me a piece of candy) Prices must be between $0. 05 -$1

More Warm Up – Discuss List your favorite brand for the following: 1. Jeans 2. Shampoo 3. Shoes Explain why you like these particular brands?

1. Perfect Competition BEFORE WE BEGIN!! This is a theoretical situation. NO TRUE Perfectly Competitive Market exists. IT IS ONLY A THEORY! SWS 2006 10

The 5 conditions of perfect competition 1) LARGE number of SMALL firms. No single buyer or seller can influence the price. 2) Buyers and sellers deal in identical products. No product differences. (EXAMPLES: Salt, Flour, Commodity, Corn) 3) Unlimited Competition: so many firms, that suppliers lose the ability to set their own price. 4) No Barriers to Entry. Sellers are free to enter the market, conduct business and free to leave the market. (Low cost to enter) 5) Each firm is a PRICE-TAKER (more on this later) CONSUMERS HAVE THE LARGEST SELECTION OF BUYERS TO BUY GOODS FROM BECAUSE NO SINGLE GOOD IS 2006 MORE APPEALING THAN ANOTHER. 11 SWS

The 5 conditions of perfect competition 4) No Barriers to entry. Sellers are free to enter the market, conduct business and free to leave the market. Perfect competition is the opposite of monopoly. Here, any firm can get into the market at very little cost. v Suppose there was a market for apples. Growing apples requires little start-up cost. v All you need are apple seeds, soil, water, and some sunlight. v There is no difference between one apple and another, so the market has a similar product. The agricultural market is the best example of a perfectly. SWS competitive market. 2006 12

Perfect Competition v Each individual firm is too small to influence prices. v Price becomes fixed to everyone in the industry. EXAMPLE: Apples from Washington vs. Apples from California (A Granny Smith is a Granny Smith!!!) No way to differentiate = no market power 13

Perfect Competition Firms in a perfectly competitive market are price takers. (they take the price they are given, they can’t change the price) Since they have no control over their own NO MARKET POWER prices, they have ____________. MARKET POWER = “the ability to set one’s OWN prices” v In other words, no one will buy an overpriced apple. Why should they? v A 4 -cent apple is the same as the 3 -cent one, so there is no reason to spend that extra penny. 14

Costa Rican Coconuts SWS 2006 15

Perfect Competition Simulation Sell me an apple! In your small group come up with a price and quick advertising to try and sell me an apple. Your cost of producing the apple is basically $0. 01. Any price over that is profit for your group. We will do three rounds of this. 16

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What is the most you would pay for a white t? SWS 2006 18

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Perception of value!!! SWS 2006 20

Monopolistic Competition The 5 conditions of Monopolistic Competition 1) LARGE number of large companies (but fewer than perfect competition). Sellers can influence the price through creating a product identity (more on this later) 2) Products are NOT exactly identical, BUT VERY SIMILAR, so companies use PRODUCT DIFFERENTIATION 3) Heavy Competition: Firms must remain aware of their competitor’s actions, but they each have some ability to control their own prices. 4) Low Barriers to Entry: harder to get started because of the amount of competition. 5) Monopolistic competition takes its name and its structure SWS 2006 from elements of monopoly and perfect competition. 21

Monopolistic Competition It is a blend of a Monopoly and a Perfectly Competitive Market – Firms have a Monopoly on their brand/name (Nike is only firm who can use a swoosh) – But it is like a Perfectly Competitive market, in that many other firms make similar (almost exact products) SWS 2006 22

So how do firms in this market make money? !!! Separate themselves from the rest – Product differentiation – Brand identity – Target a specific demographic – Non-Price competition SWS 2006 23

Monopolistic Competitive Market STUDY TIP: The key idea to understanding monopolistic competition is that firms sell products that are similar, but not exactly alike. EXAMPLE: Hand Soap v v v Essentially, all hand soaps are the same. Yet firms can create a brand identity that separates their hand soap from their competitor’s. This brand identity can be formed through packaging, product support, and especially advertising. If effective, consumers will positively identify a certain brand purchase it even if hand soap costs more. SWS 2006 24

Conditions of Monopolistic Competition The point is that firms in Monopolistic Competition must use Product Differentiation & Non-price Competition to sell their products. Product Differentiation: v. The real or imagined differences between competing products in the same industry. v. Differences may be real or imagined. v Differentiation may be color, packaging, store location, store design, store decorations, delivery, service…. . anything to make it stand out! SWS 2006 25

Conditions of Monopolistic Competition The point is that firms in Monopolistic Competition must use Product Differentiation & Non-price Competition to sell their products. Non-Price Competition: v Non-Price Competition involves the advertising of a product's appearance, quality, or design, rather than its price. v Advertising to help the consumer believe that this product is different and worth more money. Notice these commercials never VS price. mention SWS 2006 26

Examples of Monopolistic Competition Auto, Steel, Gas, Fast Food, Airlines. SWS 2006 27

Monopolistic Competition Gap Levis Lucky Same as pure competition except for product differentiation

Monopolistic Competition Are these shampoos/conditioners different? Pantene $14. 50 Frederic Fekkai $54

Monopolistic Competition Are these mascaras different? Maybelline Sisley $4 $43

Demographics matter!!!

Fashion Industry TED Talk: 1) What allows for competition to thrive in the fashion industry? 2) What have been some of the outcomes from this? 3) Do you agree with the speakers point about how all markets should operate? 4) Would this work in a market for technology? Life saving medicines? Explain. SWS 2006 32

A Trip to Ralph’s On a scale of 1 -10, how competitive is the soda market? – 10 being very competitive, 1 being not competitive. What would be some of the issues that could arise in a market with only 2 sellers? How hard would it be for a new firm to enter the market for soda? SWS 2006 33

MERGERS OF LARGE COMPANIES v Cutting into competition – when companies merge!!! v Many get “swallowed up” by another company. This “takeover” or acquisition of a company is known as a merger. There are THREE types of mergers: HORIZONTAL, VERTICAL, and CONGLOMERATE. 1. ) HORIZONTAL: involve firms in the SAME market, such as between two oil companies. Reason: Diversification 2. ) VERTICAL: involve one firm buying a resource provider. EXAMPLE: steel company buys an automaker 3. ) CONGLOMERATE: a company buys a business in a UNRELATED industry. SWS 2006 34

Conglomerate SWS 2006 35

What is an Oligopoly? A market in which a two-three large sellers control most of the production of a good or service and they work together on setting prices. Conditions of an Oligopoly 1) Very few Sellers that control the entire market. 2) Products may be differentiated or identical (but they are usually standardized) 3) Medium barriers to entry: Difficult to Enter the market because the competitors work together to control all the resources & prices. 4) The actions of one affects all the producers. 5) Collusion = an agreement to act together or behave in a cooperative manner. 36 SWS 2006 36

What is an Oligopoly? A market in which a two-three large sellers control most of the production of a good or service and they work together on setting prices. Conditions of Oligopoly 5) Collusion = an agreement to act together or behave in a cooperative manner. v Collusion Agreements: usually illegal, among producers to fix prices, limit output, or divide markets. (hard to prove that a group of companies is doing this) v It is also called Price Fixing: setting the same prices across the industry. THIS IS IN VIOLATION OF ANTI-TRUST LAWS. WHY? Basically, the companies are acting a one large monopoly. SWS 2006 37

Who is this and what does he have to do with Oligopolies? Cartels: an association of manufacturers or suppliers with the purpose of maintaining prices at a high level and restricting competition. (Cartel = another term for Oligopoly market)

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Oligopoly

Why would it make sense for the countries to work together? SWS 2006 41

Oligopoly Few producers control supply and price

Price Behavior in Oligopoly Now, sometimes businesses do not agree with each other about the price, and if that happens, a WAR will result. Price Wars: Series of price cuts that competitors must follow or lose business. v it is a fierce price competition between sellers, sometimes the price is lower than the cost of production. v. Why is that bad? ? ? v Oligopolists would like to be Independent Price setters: Ø a firm sets prices based on demand, cost of input and other factors (not based on other companies prices). SWS 2006 44

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Prisoners Scenario: Which one would you chose? Confess to the crime of armed robbery and we will let you off with a light term of 5 years in jail with parole after 3 year. Remain silent and we will throw everything we have at you, you will get 20 years in jail, because we promise you, your accomplice will talk. However, if you both remain silent, we have to let you go with a slap on the wrist, just 1 year in jail for trespassing.

Game Theory (Prisoner’s Dilemma) SWS 2006 49

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Luxoticca Video What type of market structure would you consider the eyeglass market? What are some examples of horizontal mergers for luxoticca? What are some examples of vertical mergers for luxoticca? What has happened to the average price of eyeglasses? How difficult would it be to enter this market? (barriers to entry)

2 Types of Price Behavior in an Oligopoly Price Leader (price maker): independent pricing decisions made by a dominate firm ADVANTAGE: you are the company leading the price. Independent Pricing: policy by a competitor that ignores other producer’s prices. (Might result in death by price war!!!!!) DISADVANTAGE: other firms shut you down by agreeing to set lower prices than yours.

Quick Questions - How much $, time, and effort went into creating a simple drug like Advil? - Should the company that created Advil be allowed to keep their product ingredients secret? - Pros/Cons of not protecting their ideas/product?

Why was he to do this? Is this right or wrong? SWS 2006 56

Conditions of Monopoly Exact Opposite of Pure Competition. v A price maker. (set their own price, without regard to supply and demand) v There is a single seller v No close substitute goods are available v High Barriers to Entry: Other sellers cannot enter the Market. SWS 2006 60

4 Distinct Types of Monopolies: 1) Geographic Monopoly 2) Natural Monopoly 3) Technological Monopoly 4) Government Monopoly SWS 2006 61

Types of Monopolies Geographic Monopoly: The only business in a location due to size of market. v Decreasing in the U. S. because of mobility. EXAMPLE: Only person selling water in the desert. SWS 2006 62

Natural Monopoly: Where costs are minimized by having a single producer of the product. v. Gas, water, electricity: government creates Natural Monopolies by Franchising some utilities. Ø Franchise - the right to produce or do business in a certain area without competition. Ø Government franchises come with government regulation. LADWP WHY WOULD GOVERNMENT DO THIS? ? ? Economies of Scale: As natural monopolies grow larger, this reduces its production costs (economies of scale). v. Firms become more efficient as the firm becomes larger. Ø Example: LADWP 1 customer vs. 1 million customers. Can offer a cheaper product/service as they get more customers.

Economies of Scale – the more you make the cheaper it becomes per unit Firms competing leaves average cost here = high prices for customers. They divide up the market tal o t ith a w rm offer WP i f gle l can LAD n i ( S tro e c i n co er pr low SWS 2006 64

Buy in Bulk – Walmart Effect (economies of scale) SWS 2006 65

Types of Monopolies Firm has discovered a new process or product. 3) Technological Monopoly: Constitution gave government the right to grant technological monopolies. (Intellectual Property) § Patent: 17 years exclusive rights to a developed technology. (funny patents – click here) § Copyright: (Artists and writers) Life plus 50 years.

Happy Birthday!!

Thicke and Pharrell lost the lawsuit and had to pay $7. 5 million to Marvin Gaye’s estate. SWS 2006 68

Types of Monopolies 4) Government Monopoly: government. Retained by the v Liquor sales in some counties, uranium production, water, etc. SWS 2006 69

Price Discrimination When monopolies have total market control they can charge different demographic groups different prices Typical of a monopoly or a company with a large share of the market Examples: discounted airlines, rebate offers, senior discounts, student discounts, children fly free. SWS 2006 71

Quick Break

3 Conditions of Efficient & Successful Markets work best when three conditions are met: 1) Adequate competition must exist in all markets. 2) Buyers and sellers are reasonably wellinformed about conditions and opportunities. 3) Resources must be free to move from one industry to another. Market Failure occurs when any of the 3 conditions alter significantly. SWS 2006 73

The Role of Government has the power to maintain competition, regulate monopolies, or to run government-owned monopolies. v Since the late 1800 s the US have passed laws to restrict and regulate monopolies and trusts. § Trust: a legally formed combination of companies. SWS 2006 75

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The Role of Government Antitrust Legislation Interstate Commerce Act: Passed by Congress in 1887. It was aimed at the railroads. Charges of unfair pricing prompted Congress to act. 1887 PRESENT 18 87 : In ter sta t e. C om me rc e. A ct SWS 2006 79

The Role of Government 1890 - Sherman Antitrust Act - law against monopolies that hindered competition or made competition impossible because of the “restraint of trade” that is created by a monopoly. 1887 PRESENT 18 87 18 90 : In ter sta t : S he e. C om me rc rm an An tit r e. A ct us t. A ct SWS 2006 80

The Role of Government 1914 - Clayton Antitrust Act - outlawed price discrimination - charging different customers different prices for the same product. Further defined Sherman. (preferred pricing) 1887 PRESENT 18 87 18 90 : In ter sta t : S 19 he e. C om me rc rm an 14 lay to An n. A nt itr tit r e. A ct : C us t. A ct SWS 2006 Ac t 81

The Role of Government 1914 - Federal Trade Commission Act - passed to enforce the Clayton Antitrust Act. It gave the authority to issue Cease and Desist order. Cease and Desist Order: FTC ruling requiring a company to stop an unfair business practice that reduces or limits competition. 1887 PRESENT 19 19 14 14 : C : F : In : S h lay ed ter er to era sta ma n. A l. T te n. A nt rad Co nt itr e mm itr us C us t A om er t. A ce ct mi ct ss Ac ion t 18 87 18 90 SWS 2006 Ac t 82

When to Regulate Government will step in to ensure a competitive market – Analyze mergers/takeovers – Break-up monopolies – Regulate prices The Department of Justice will use two measures when deciding when to regulate 1. Concentration Ratio 2. Herfindahl-Hirschman Index

Concentration Ratios The concentration ratio: the percentage share of industry sales of the top 4 (leading) firms in the industry. – Industries with high concentration ratios are very oligopolistic.

Concentration Ratios in Selected Industries, 2010

Calculate the Concentration Ratio (CR) Firm A B C D E F G H I J Total Percent of sales 14 % 4 23 5 2 8 17 10 2 5 100 % Concentration ratio is 23 + 17 + 15 + 14 = 69 Govt. will typically step in at 75%

Oligopoly in the Automobile Industry: The Growing Influence of Foreign Firms April 2010 data

Herfindahl-Hirschman Index (HHI) HHI: the sum of the squares of the market shares of each firm in the industry. – A monopoly has 100% of the market share. – 1002 = (100 x 100) = 10, 000 – You cannot get a bigger HHI number than 10, 000.

Calculate the HHI: the sum of the squares of the market shares of each firm in the industry. An industry has 2 firms, each with 50% of the market. – HHI = 502 + 502 = 2, 500 + 2, 500 = 5, 000 An industry has 4 firms, each with 25% of the market. – HHI = 252 + 252 = 625 + 625 = 2, 500 The U. S. Department of Justice uses the HHI to decide whether an industry is highly competitive; it considers an industry with HHI < 1, 800 competitive.

STUDY FOR YOUR TEST!! SWS 2006 93