Lecture 15: Imperfectly Competitive MarketsOutline:

1. The Structure of the US economy

2. Characteristics of imperfectly competitive market structures

i. Firms select their product

ii. Firms administer their prices

iii. Non-price competition

iv. Creation of barriers to entry

3. Theory of Monopolistic Competition

i. Assumptions of MC

ii. SR profits of the MC firm

iii. LR profits of the MC firm

iv. Trade-off between variety and cost per unit

4. Theory of Oligopoly

i. Assumptions of Oligopoly

ii. Natural Causes of "bigness" - economies of scale, economies of scope

iii. Strategic behavior - cooperation and competition

iv. LR strategic barriers to entry

a. Brand proliferation

b. Set-up costs

c. Predatory pricing

v. Public Policy and Oligopoly

5. Dollars and Sense: Article 22

6. New Field Guide: 9.9

1. The Structure of the US economy:

* 2/3 of the GDP of the US is produced by firms that are small in absolute size or small in relation to the market that they operate in.

* Most of these firms do not fit the definition of perfect competition - they are what we call monopolistically competitive.

Examples of MC markets: retail trades and services - local supermarkets, local shops, local restaurants.

* 1/3 of the GDP of the US is produced by industries that are dominated by either a single firm or by a few large firms.

* Most of these are not monopolies - they are what we call oligopolies.

Examples of Oligopoly markets: media, airlines, pharmaceutical drugs, long distance telephone.

Market concentration:

One measure of the extent to which firms in a market have significant "potential" market power is how concentrated the market is.

Concentration ratio= Measures the fraction of total market sales that are controlled by some specified number of the industry's largest sellers.

Eg. Four-firm concentration ratio measures the fraction of total market sales of the four largest firms in the industry.

2. Characteristics of Imperfectly Competitive Markets:

* Firms select their products:

MOST firms in imperfectly competitive markets sell differentiated products. In some cases the firm must decide what characteristics to give the product that it sells.

* Firms administer prices:

When firms sell differentiated products they have to decide what price to quote for their product since each product has its own market but it also has close substitutes.

Administered prices are set by the conscious decision of the firm rather than by market forces - firms that administer prices are called price makers. Once prices are set the firm lets demand determine its sales.

* Non-price competition:

Many firms spend large amounts of money on differentiating their product through advertising, through quality differences, and through product guarantees.

* Entry Prevention:

Many firms spend money on things that create barriers to new firms entering the market. Advertising costs if they are large can be a barrier to a new firm entering a market.

3. Monopolistic Competition:

Characteristics of MC:

1. There are many small firms in the industry.

2. Each firm produces one specific brand or variety of the industry's product.

3. Each firm makes its own price and output decisions.

4. There is freedom of entry and exit.

SR profits of the MC firm:

GRAPHS

Note:The graph for the MC firm looks just like the graph for the Monopolist - but the demand curve the MC firm faces will be more elastic (the good has close substitutes).

LR profits of the MC firm:

Because of the assumption of freedom of entry and exit - MC firms will only earn normal profits in the LR.

Trade-off with MC:

* In the LR MC firms don't produce at the lowest cost per unit of output (min ATC) because they produce a differentiated product.

Benefits of a differentiated product = consumers have choices

Costs of a differentiated product = price is not as low in the LR because the firm does not produce at the lowest cost per unit of output.

* There is no consensus on whether the benefits outweigh the costs of monopolistic competition from an economic stand point, but from the perspective of consumers it seems that the benefits of choice outweigh the costs in terms of higher price.

4. Oligopoly:

Characteristics of Oligopoly:

1. Two or more large firms dominate the market - account for a large share of total market sales.

2. Firms produce either differentiated or homogenous products.

3. Firms make price and output decisions strategically - with other firms in mind.

4. There are barriers to entry.

Note: Because of the assumption of strategic behavior there are many different models of oligopoly.

Causes of bigness/ barriers to entry:

Reasons for the large size of oligopolies and for their ability to prevent competitors from easily entering their markets:

"Natural" causes:

* Economies of scale:

Cost advantages associated with the division of labor and large scale production.

* Economies of scope:

Product development is costly and usually involves large fixed costs - if the firm can sell a large quantity of the product it can more easily recover these fixed costs.

"Artificial" causes:

* Mergers and acquisitions:

Firms join with other firms or take-over other firms.

* Predatory pricing:

Firms price their products below marginal cost, explicitly to drive competitors out of business.

* Brand proliferation:

Firms produce products under different brand names and work to establish brand loyalty among customers.

* Advertising:

Firms spend large amounts of money on advertising so that any firm that wants to enter the market must also be able to spend large amounts on advertising to make consumers aware of their product.

Strategic Behavior - Competition and Cooperation:

*Oligopoly behavior differs depending on the market. But because of the strategic nature of the interactions between firms, in some cases there are incentives for competition, and in others there are incentives for cooperation.

Incentives for cooperation:

* If firms can collude and act as a single firm they can earn monopoly profits.

* Such collusion is illegal in the US

* A formal organization where firms act as a single firm, is called a cartel.

Eg. OPEC

* A cartel works by getting individual firms to agree to voluntary output quotas - where the total amount of output produced is equal to the monopoly output - and the price they can charge is

the monopoly price.

* The instability of cartels comes from the fact that firms that are colluding also have an incentive to "cheat" and increase their output and individual profits at the expense of the group.

Incentives for competition:

* Firms also have an incentive to compete to capture market

share from their rivals.

Eg. Price wars among airline companies.

* Extreme forms of competition (cut-throat) such as predatory pricing (P<MC) are illegal in the US.

Public Policy and Oligopoly:

Benefits of Oligopoly:

* Oligopolies have the resources to undertake research and development and innovation. This produces significant benefits to consumers in terms of new products and processes and in some cases lower prices.

Costs of Oligopoly:

* Oligopolies have an incentive to collude rather than compete

* They have an incentive to spend real resources to create barriers to entry to keep prices and profits high rather than to improve products and lower costs.

The challenge of Oligopoly for public policy makers:

* To encourage competition rather than collusion among oligopolies

*To prevent concentration of power that seeks to make industries less competitive.

Examples of policies:

*Use of anti-trust policy to prevent mergers and acquisitions

* Regulations on the quality of products

* Regulations on the extent to which firms can collude

* Subsidies (tax breaks) for research and development which is considered "desirable"