imperfect competition

Chapter 11

Imperfect Competition

(Part IV)

© 2004 Thomson Learning/South-Western

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APPLICATION 11.3: Price Leadership in Financial Markets

The Prime Rate at New York Commercial Banks– Major New York commercial banks quote a “prime

rate” which purports to be the interest rate that they charge on loans to their most creditworthy customers.

– Recent research indicates actual pricing is more complex, but the prime provides a visible and influential indicator or rate change.

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While rates changes are sluggish, when “large” changes (0.25 or more) are required one of the major banks will act like a leader and announce a new prime rate on a trial basis.

After a few days, either most banks will follow or the initiator will return to its old rate.

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– A number of researchers have found that rates tend to rise soon after an increase in bank costs, but decline only slowly when costs fall.

– Similarly, a rise in the prime tends to hurt the stock prices of banks that increase because the increase signals that profits hare being squeezed by costs.

– Alternatively, stock prices rise when the prime rate falls.

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Price Leadership in the Foreign Exchange Market– The large market for world currencies is dominated

by major financial institutions and is heavily influenced by the “intervention” of various nations’ central banks.

– Because central bank intervention is not announced in advance, well informed traders may have an information market advantage.

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– In a study of the German Mark (DM), an author found that one bank tended to pay the role of leader in setting the DM/$ exchange rate.

– This leadership role arose because of the bank’s ability to foresee intervention by the German central bank in exchange markets.

Quoted exchange rate between 25 and 60 minutes before the intervention were copied by other banks, while within 25 minutes (with information more diffused) no clear cut pattern emerged.

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APPLICATION 11.4: Competition in Breakfast Space

Industrial Concentration– Three major firms control approximately 80 percent

of the market.– Returns on invested capital are more than double

those of the average industry.– It is unclear why the market is not more competitive

since there do not seem to be any major economies of scale and no obvious barriers to entry.

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The FTC Complaint and Product Differentiation– In 1972 the U.S. Federal Trade Commission (FTC)

claimed the largest producers actions tended to establish monopoly-like conditions.

Proliferation of new, highly advertised, brands left no room for potential new entrants.

Brand identification also prevented new entrants from duplicating existing cereal.

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Demise of the Legal Case– Firms claimed that they were engaging in active

competition by creating new cereal brands.– Also, many new “natural” cereals did enter the

market in the 1970s.– The case was quietly dropped in 1982.

Recent studies still indicate a lack of competition and continued higher profits.

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One of illustrating the contention that major firms so proliferated their brands so as to keep potential competitors out was developed by S. Salop.

Figure 1 depicts consumers evenly located along the circle which may represent an actual geographic space or product space.

The presence of two firms (A and B) with two products each deters entry by C.

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Application Figure 1: Salop’s Model of Spatial Competition.

.

..

. B1

B2

A1

A2

C

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Product Differentiation: Entry by New Firms

The degree to which firms can enter the market plays an important role.

Even with few firms, to the extent that entry is possible, long-run profits are constrained.

If entry is completely costless, long-run economic profits will be zero (as in the competitive case).

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Monopolistic Competition

If firms are price takers, P = MR = MC for profit maximization.

Since P = AC, if entry is to result in zero profits, production will take place where MC = AC (at minimum average cost).

If, say through product differentiation, firms have some control over price, each firm faces a downward sloping demand curve.

imperfect competition

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