john sloman keith norris powerpoint to accompany
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John SlomanKeith Norris
PowerPoint to accompany
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Purpose of Lecture – Imperfect Competition
• Explain key differences in firm behaviour and market structure:
- Re: Oligopoly compared to Monopolistic Competition.
• So that analysis and comparison can be performed:
– Determination of profit maximising price and output (short and long-run);
– Calculation of normal and supernormal profits (short and long-run);
– Determination of shut-down points (short and long-run).
Imperfect Competition
Chapter 7
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Monopolistic Competition• Assumptions of monopolistic competition
• Large number of firms:
– (Each has small share of market – so not affecting rival to any great extent);
• Independence:
– Each firm makes their decision not worried about its affect on rival;
• Freedom of entry:
• Product differentiation:
– Products & services vary across rivals;
– Can raise price without losing all customers;
– Downward sloping demand curve – relatively elastic given large number of competitors consumers can turn to.
– examples in Australia
• Petrol stations, hairdressers, restaurants & builders;
• Many firms in industry but usually only one in a location (retailing, newsagents – local monopoly can charge higher prices)
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Monopolistic Competition• Short-Run equilibrium of the firm:
- Figure 7.1 (a) same for monopoly except AR and MR curves more elastic;
- Short run profit max. MC = MR;
- Can make supernormal profit (short-run):
- As does perfectly competitive firm (shaded area);
- Depends on demand strength, position & elasticity;
- Increases with product differentiation;
- Firm’s SR-Profit greater when D curve is less elastic &
further to the right of the AC curve
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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AR D)
MC
AC
MR
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Short-run Equilibrium of the Firm Under Monopolistic Competition
Economic Profit
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Monopolistic Competition
• New firms enter when supernormal profits are being made;
• New firms steal customers from established firms;
• Demand for established firms product falls:- Their D (AR) curve will shift leftwards as
long as supernormal profits remain and new firms keep entering;
• LR equilibrium only normal profits & no incentive for entry (Figure 7.1 (b)) next slide.
• To right of equilibrium, LRAC is > AR and < normal profits are made.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
ARL DL)
MRLQ 0 QL
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LRAC
LRMC
Long-run Equilibrium of the Firm Under Monopolistic Competition
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John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Long-run Equilibrium of the Firm Under Monopolistic Competition
• Non-price competition• Product development:
– To produce a high demand product;– Different from rival’s product;– Better than rivals (personal service, late opening, certain lines
stocked, etc.);– Inelastic demand due to lack of close substitutes;
• Advertising:- To sell the product;- Increases demand and makes the demand curve less elastic (stresses product qualities over that of rivals);
- Optimal advertising is where MRA = MCA;
- As long as MRA > MCA additional advertising will add to profits
- Extra amounts spent on advert. Will lead to smaller & smaller increases in sales;
- Thus MRA falls until it is = MCA, then no further profit can be gained from adverts.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Monopolistic Competition• Product development and advertising effects on D are difficult to forecast.
- Different effects at different prices;
- Profit Max. involves opt. combination of price, product type, advertising level & variety.
• The public interest - comparison with perfect competition:
- Higher price & lower quantity;
- Not producing at least-cost point;
- Therefore have excess capacity (could move to Min. LRAC);
- Large number of firms (petrol stations) all operating at less than optimum output & hence being forced to charge a higher P than could with bigger turnover;
- Difference with Perfect Comp. likely to be small;
- Downward sloping D curve likely to be highly elastic due to large number of substitutes;
- Greater variety of products to choose from;
- each firm may satisfy some particular requirement of particular consumers
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Monopolistic Competition• Comparison with monopoly:
- V.similar to comparing monopoly with perfect competition;
- Prices kept down by freedom of entry and lack of supernormal profits (cost savings);
- Less economies of scale than monopoly hence less funds for investment and R&D.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education AustraliaQ2
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competition
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DL under monopolistic
competition
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Figure 7.2 Long-run Equilibrium of the Firm Under Perfect and Monopolistic Competition
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John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly• Key features of oligopoly:
- Few firms share large portion of the industry;
- Virtually identical products e.g. metals, chemicals, sugar, petrol) or,
- Differentiated products e.g. cars, soap powder, soft drink, banking services;
- Competition is in brand marketing
(1) Barriers to entry:
– several similar to monopoly (p. 122);
– Vary from industry to industry (some cases easy in others virtually impossible).
(2) Interdependence of the firms:
- Only a few firms each affected by other’s actions - so take account of each other’s
decisions;
- So mutually dependent – very difficult to make predications without knowing how
rivals will react: - no general accepted theory of oligopoly;
(3) Examples in Australia:
- Motor vehicle industry, banking industry, supermarket retailers
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly
The Banking Oligopoly
Shares of Total Banking Assets, 2006 (%)
Commonwealth Bank 18.6National Australia Bank 18.2Westpac 15.2ANZ 14.6All other banks 33.3
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly – Two Incompatible Directions:
• Collusion from firm interdependence:
- Cartel acts like a monopoly to jointly maximise profits;
• Competition to gain bigger share of industry profits for themselves causes aggregate profit loss:
- Price competition drives down average industry Price;
- Competition through advertising raises industry costs.
• Equilibrium of the industry:
- For cartel:
(1) Firms agree on prices, market share, advertising exp, etc.
(2) Reduces their uncertainty and fear of competitive price cutting or retaliatory advertising – both could reduce total industry profits;
(3) can compete against each other using non-price competition or allocate quotas. If quota sum > Q1 price would have to fall to clear.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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Industry D AR
Profit-maximising Cartel
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John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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Industry D AR
Industry MC = Horizontal sum of individual firms
Industry MR
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Profit-maximising Cartel
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John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly• Tacit collusion
– Firms keep to a price set by established leader (told price), or
– Firms constantly follow leader’s changing prices (follow price):
• Leader may prove reliable to follow - best barometer of market conditions;
• Barometric firm price leadership (barometric firm may change frequently):
– Problems:
• Assumes followers will want to maintain a constant market share;
• Followers may want to supply more at higher price, or
• Followers may decide to maintain market share for fear of retaliation from the leader like price cuts or aggressive advertising campaign.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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Assume constantmarket share
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Price Leader Setting Price -Aiming to Maximise Profits for a Given Market Share
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John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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Price Leader Aiming to Maximise Profits for a Given Market Share
(Barometric method is similar – Although firm not dominating)
$
a
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly• Tacit collusion – Other forms
– Average cost pricing:
• Add a percentage for profit on top of average costs;
• Used in inflationary times – rule of thump;
– Price benchmarks:
• Will round up to $9.95, $14.95, $19.95 but not $12.31, $16.42, $20.04;
– Both Methods:
• Applied to advertising – no criticism of other products only praise your own (no everlasting light bulb)
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly• Factors favouring collusion
– Few firms – well know to each other;
– Open with each other about costs & production methods;
– Similar production methods and average costs:• Therefore will want to change prices at same time by same
percent.
– Similar products & can reach price agreements;
– There is a dominant firm;
– Significant entry barriers – little fear of disruption by new firms;
– The market is stable – sets certainty for agreements;
– No government measures to curb collusion.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly• Breakdown of collusion is concerned with:
– Price, quantity, advertising & product development;
– Strategy choice depends on anticipated rival reaction & willingness to gamble.
• Game theory:
– Assume 2 firms with identical costs, products and demand;
– Both considering alternative price to charge – table 7.1 shows profit payoffs;
– Maximum and Minimum payoffs;
– Nash equilibrium – equilibrium outcome where there is no collusion between the players;
– Prisoner’s dilemma – tempted to cheat and cut prices from collusion;
– Importance of timing of decisions.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
$2.00 $1.80
$2.00
$1.80
X’s price
Y’s price
A B
C D
$10m each
$8m each$12m for Y$5m for X
$5m for Y$12m for X
Profits for Firms A and B at Different PricesTable 7.1
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Not confess Confess
Notconfess
Confess
Sue's alternatives
Bill'salternatives
A B
C D
Each gets1 year
Each gets3 years
Bill gets3 monthsSue gets10 years
Bill gets10 yearsSue gets3 months
The Prisoners' Dilemma
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly
• Ampol promises to match a competitors price within a radius:
- Competitors believe this promise;
- Competitors believe that Ampol will not undercut their price;
- what price for the only other petrol station in region?
- Price that will maximise its profits assuming that Ampol will charge the same price;
- In absence of other providers, is likely to charge a relatively high price;
- Now assume several petrol stations in locality, so what should the company do know?
- Perhaps charge same as Ampol and hope that no other company charges lower forcing Ampol to cut its price?
- Assuming that Ampol’s threat is credible, other companies are likely to reason similarly.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly
• Importance of Timing:
- Most decisions are made firms individually rather than similtaneously;
- Sometimes an individual firm will take the initiative at other times it will respond to the decision of the other firms;
- The following decision try illustrates this:
- Assume a market for both a 500 seater and 400 seater version of new type of aircraft;
- But not big enough for two airlines – Boeing and Airbus;
- Assume:
(1) 400 seater => $50m annual profit to single manufacturer;
(2) 500 seater => $30m annual profit to single manufacturer;
(3) If both manufacturers produced the same version they would each make an annual loss of $10m
- There is clearly a first mover advantage in decision tree:
(1) Once Boeing decides to build the more profitable version of the plane, Airbus is forced to build the less profitable version;
(2) Naturally, Airbus would like to build the more profitable version, and be the first mover;
(3) Which airline moves first depends on their advanced R&D and production capacity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Boeingdecides
500
seat
er
500 seater
500 seater
400 seater
400 seater
400 seater
Boeing –$10mAirbus –$10m
(1)
Boeing +$30mAirbus +$50m
(2)
Boeing +$50mAirbus +$30m
(3)
Boeing –$10mAirbus –$10m (4)
Airbusdecides
B2
Airbusdecides
B1
A
A Decision Tree
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly• More complex decision trees:
– The ‘game’ becomes more like chess;
– With many moves and several options on each move;
– Greater than two companies the decision tree becomes more complex still;
• More complex ‘games’ can be devised:
- With more than two firms, many alternative prices, differentiated products, and various forms of non-price competition (e.g. advertising);
- In such cases, the cautious (maximin) strategy may suggest a different policy (e.g. do nothing) from high risk (maximax) strategy (e.g. cut prices substantially);
- Firms can alter their tactics in the light of new circumstances;
- They may compete for a while, then realise that no one is winning, then jointly raise prices and reduce advertising;
- Later, after a period of tacit collusion, competition may break out again;
- Caused by entry of new firms;- New product designs;- Change in market demand;- Temptation to cheat.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly – Non-Collusive & the kinked demand curve• Oligopolists face a kinked demand curve during price wars and are therefore
reluctant to change their prices:
• One oligopolist cuts its price:
• Rivals will feel forced to follow suit to prevent losing customers to the first firm;
• One oligopolist raises its price:
• Rivals will not follow suit to gain customers from the first firm;
• Kinked demand curve at current price and output (Figure 7.6):
– Rise in price: (1) Large sales revenue fall as customers switch to lower priced rivals;
(2) Hence a reluctance to raise price;
(3) Demand is relatively elastic above the kink;
– Fall in price (1) Brings only modest sales increase;
(2) Because rivals lower their prices to and customers do not switch;
(3) Firm is reluctant to reduce its price;
(4) Demand is relatively inelastic below the kink
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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Kinked Demand for a Firm Under Oligopoly
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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Kinked Demand for a Firm Under Oligopoly
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John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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Stable Price Under Conditions of a Kinked Demand Curve
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John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly and the Consumer
• Oligopolistic firms are also reluctant to change prices because it:
– Involves modifying price lists;
– Working out new revenue predications;
– Revaluing stock of finished goods;
– May upset customers;
– Colluding like monopoly to charge high prices – not in consumer interest.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly and the Consumer• More of a disadvantage than monopoly for consumer:
- May be less scope for economies of scale to mitigate the effects of market power;
- Oligopolists are likely to engage in more extensive advertising than monopolist;
- These are less severe with no oligopolistic collusion, some price competition and weak barriers to entry;
- Oligopolistic power can be offset (in some markets) if they sell their product to other powerful
firms (supermarket – countervailing power).
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Oligopoly and the Consumer• Oligopolistic advantages over other market structures:
- Can use part of supernormal profit for R&D (like monopolies);
- have considerable incentive to do so (unlike monopolies);
- product improvement results in greater market share and rivals may take some time to respond;
- Lowered costs from technological improvement => higher profits => withstand price war;
- More consumer choice from product differentiation;(car stereo equipment & non price competition);
- Difficult to draw general conclusion, since oligopolies differ so much in performance.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Price Discrimination• Meaning of price discrimination:
• Different prices for different population groups (markets) when production costs do not vary.
– First degree:• Approximate examples in Australia could include bargaining
at market stalls, and some services.
– Second degree:• Examples in Australia include water, electricity,
bulk buying.
– Third degree (the most common form):• Examples in Australia include cinema tickets, airline tickets,
rail and bus tickets (adults, children, pensioners, etc.)
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Price Discrimination• Conditions necessary for price discrimination:
- Firms must be able to determine own price (not price takers such as in perfect competition);
- Separate markets – consumers in one market cannot resell in another market at increased price (children’s tickets resold as adult tickets);
- Differing demand elasticities in each markets;
(1) A higher price where demand is less elastic and hence less sensitive to price rise.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Price Discrimination
• Advantages to the firm:
- Earns higher revenue from any given level of sales (Figure 7.7)
- Drive competitors out of business - Predatory pricing
(1) A monopoly in one market (e.g. home market) may charge a high price due to its
relatively inelastic demand and thus make high profits;
(2) If it is under oligopoly in another market (e.g. export market) it may use the high
profits in the first market to subsidise a very low price in the oligopolistic market,
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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Revenue froma single price
Third-degree Price Discrimination
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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A higher discriminatoryprice is now introduced
Third-degree Price Discrimination (Figure 7.7)
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
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John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia
Price Discrimination and the Consumer
• Some benefit and others lose;
• Those paying the higher price will feel unfairly treated;
• Those charged the lower price may be able to obtain a good or service they could otherwise not afford:
- Concessionary bus fares for senior citizens.
• Allows for increased profits and sometimes less competition