Microeconomics for MBAs - Chapter 13 doc

CHAPTER 13 Imperfect Competition and Firm Strategy Differences in tastes, desires, incomes and locations of buyers, and differences in the use which they wish to make of commodities all indicate the need for variety and the necessity of substituting for the concept of a “competitive ideal,” an ideal involving both monopoly and competition. Edward Chamberlin e have so far considered two distinctly different market structures: perfect competition, characterized by producers that cannot influence price at all because of extreme competition; and pure monopoly, in which there is only one producer of a product with no close substitutes and whose market is protected by prohibitively high barriers to entry. Needless to say, most markets are not well described by either of those theoretical structures. Even in the short run, producers typically compete with several or many other producers of similar, if not identical, products. General Motors Corporation competes with Ford Motor Company, Chrysler Corporation, and a large number of foreign producers. McDonald’s Corporation competes with Burger King Corporation, Hardees, and a lot of other burger franchises, as well as with Pizza Hut, Popeye’s Fried Chicken, and Long John Silver’s. People’s Drug stores compete directly with other drug chains and locally owned drugstores, and indirectly with department and discount stores that sell the same non-drug products. In the long run, all these firms must compete with new companies that surmount the imperfect barriers to entry into their markets. In short, most companies competing in the imperfect markets can cause producers to be more efficient in their use of resources than under pure monopoly, although less efficient than in perfect competition. One word of caution, however: The study of so-called real-world market structures can be frustrating. Although models may incorporate more or less realistic assumptions about the behavior of real-world firms, the theories developed from them are conjectural. At best, they allow economists to speculate on what may happen under certain conditions. Real-world markets are imperfect, complex phenomena that often do not lend themselves to hard- and-fast conclusions. Monopolistic Competition As we have noted in our study of demand, the greater the number and variety of substitutes for a good, the greater the elasticity of demand for that good—that is, the more consumers will respond to a change in price. By definition, a monopolistically competitive market like the fast-food industry produces a number of different products, W Chapter 13 Imperfect Competition and Firm Strategy 2 most of which can substitute for each other. If Burger Bippy raises its prices, then, consumers can move to another restaurant that offers similar food and service. Because of consumer ignorance and loyalty to the Big Bippy, however, Burger Bippy is unlikely to lose all its customers by raising its prices. It has some monopoly power. Therefore, it can charge slightly more than the ideal competitive price, determined by the intersection of the marginal cost and demand curves. Burger Bippy cannot raise its prices too much, however, without substantially reducing its sales. The degree to which monopolistically competitive prices can stray from the competitive ideal depends on • the number of other competitors • the ease with which competing firms can expand their businesses to accommodate new customers (the cost of expansion) • the ease with which new firms can enter the market (the cost of entry) • the ability of firms to differentiate their products, by location or by either real or imagined characteristics (the cost differentiation) • public awareness of price differences (the cost of gaining information on price differences) Given even limited competition, the firm should face a relatively elastic demand curve— certainly more elastic than the monopolist’s. Monopolistic Competition in the Short Run In the short run, a monopolistically competitive firm may deviate little from the price- quantity combination produced under perfect competition. The demand curve for fast- food hamburgers in Figure 13.1 is highly, although not perfectly, elastic. Following the same rule as the perfect competitor and pure monopolist, the monopolistically competitive burger maker produces where MC = MR. Because the firm’s demand curve slopes downward, its marginal revenue curve slopes downward too, like the pure monopolist’s. The firm maximizes profits at M mc and charges P mc , a price only slightly higher than the price that would be achieved under perfect competition (P c ). (Remember, the perfect competitor faces a horizontal, or perfectly elastic, demand curve, which is also its marginal revenue curve. It produces at the intersection of the marginal cost and marginal revenue curves.) The quantity sold with monopolistic competition is also only slightly below the quantity that would be sold under perfect competition, Q c . Market inefficiency, indicated by the shaded triangular area, is not excessive. The firm’s short-run profits may be slight or substantial, depending on demand for its product and the number of producers in the market. In our example, profit is the area bounded by ATC 1 P mc ab, found by subtracting total cost (0ATC 1 bQ mc ) from total revenues (0P mc aQ mc ), as with monopolies. Chapter 13 Imperfect Competition and Firm Strategy 3 __________________________________________ FIGURE 13.1 Monopolistic Competition in the Short Run Like all profit-maximizing firms, the monopolistic competitor will equate marginal revenue with marginal cost. It will produce Q mc units and charge price P mc , only slightly higher than the price under perfect competition. (The perfect competitor’s combined demand and marginal revenue curve would be horizontal at price P c .) The monopolistic competitor makes a short-run economic profit equal to the area ATC 1 P mc ab. The inefficiency of its slightly restricted production level is represented by the shaded triangular area. Monopolistic Competition in the Long Run Because the barriers to entry into monopolistic competition are not excessively costly to surmount, substantial short-run profits will attract other producers into the market. When the market is divided up among more competitors, the individual firm’s demand curve will shift downward, reflecting each competitor’s smaller market share. As a result, the marginal revenue curve will shift downward as well. The demand curve will also become more elastic, reflecting the greater number of potential substitutes in the market. (These changes are shown in Figure 13.2.) The results of the increased competition are: • The quantity produced falls from Q mc2 to Q mc1 . • The price falls from P mc2 to P mc1 . Profits are eliminated when the price no longer exceeds the firm’s average total cost. (As long as economic profit exists, new firms will continue to enter the market. Eventually the price will fall enough to eliminate economic profit.) 1 Notice that the firm is not producing and pricing its product at the minimum of its average total cost curve, as the perfect competitor would (nor did it in the short run). 2 In this sense the firm is producing below capacity, by Q m – Q mc2 units. 1 The monopolistic competitor will still have an incentive to stay in business, however. It is economic profit, not book profit, that falls to zero. Book profit will still be large enough to cover the opportunity cost of capital plus the risk cost of doing business. Chapter 13 Imperfect Competition and Firm Strategy 4 In terms of price and quantity produced, monopolistic competition can never be as efficient as perfect competition. Perfectly competitive firms obtain their results partly because all producers are producing the same product. Consumers can choose from a great many suppliers, but they have no product options. In a monopolistically competitive market, on the other hand, consumers must buy from a limited number of producers, but they can choose from a variety of slightly different products. For example, the pen market offers consumers a choice between felt-tipped, fountain, and ballpoint pens of many different styles. This variety in goods comes at a price—the higher price illustrated in Figure 13.2. __________________________________________ FIGURE 13.2 Monopolistic Competition in the Long Run In the long run firms seeking profits will enter the monopolistically competitive market, shifting the monopolistic competitor’s demand curve down from D 1 to D 2 and making it more elastic. Equilibrium will be achieved when the firm’s demand curve becomes tangent to the downward-sloping portion of the firm’s long-run average cost curve. At that point, price (shown by the demand curve) no longer exceeds average total cost; the firm is making zero economic profit. Unlike the perfect competitor, this firm is not producing at the minimum of the long- run average total cost curve. In that sense it is underproducing, by Q m – Q mc2 units. Oligopoly In a market dominated by a few producers, where entry is difficult—that is, in an oligopoly—the demand curve facing an individual competitor will be less elastic than the monopolistic competitor’s demand curve (see Figure 13.3). If General Electric Company raises its price for light bulbs, consumers will have few alternative sources of supply. A price increase is less likely to drive away customers than it would under monopolistic competition, and the price-quantity combination achieved by the company will probably be further removed from the competitive ideal. In Figure 13.3, the oligopolist produces only Q o units for a relatively high price of P o , compared with the perfect competitor’s price-quantity combination of Q cPc . The shaded area representing inefficiency is fairly large. Exactly how the oligopolist chooses a price is not completely clear. We will examine a few of the major theories proposed. In contract, we had to examine only a 2 The perfect competitor produces at the minimum of the average total cost curve because its demand curve is horizontal—and therefore the demand curve’s point of tangency with the average total cost curve is the low point of that curve. Chapter 13 Imperfect Competition and Firm Strategy 5 single theory each for perfect competition, pure monopoly, and monopolistic competition. _________________________________________ FIGURE 13.3 The Oligopolist as Monopolist With fewer competitors than the monopolistic competitor, the oligopolist faces a less elastic demand curve, D o . Each oligopolist can afford to produce significantly less Q o and to charge significantly more than the perfect competitor, who produces Q c , at a price of P c . The shaded area representing inefficiency is larger than that of a monopolistic competitor. Theories of Price Determination Because each oligopolist is a major factor in the market, oligopolists’ pricing decisions are mutually interdependent. The price one producer asks significantly affects the others’ sales. Hence when one oligopolistic firm lowers it price, all the others can be expected to lower theirs, to prevent erosion of their market shares. The oligopolist may have to second-guess other producers’ pricing policies—how they will react to a change in price, and what that might mean for its own policy. In fact, oligopolistic pricing decisions resemble moves in a chess game. The thinking may be so complicated that no one can predict what will happen. Thus, theories of oligopolistic price determination tend to be confined almost exclusively to the short run. (In the long run, virtually anything can happen.) The Oligopolist as Monopolist Given the complexity of the pricing problem, the oligopolistic firm—particularly if it is the dominant firm in the market—may simply decide to behave like a monopolist (because it does have some monopoly power). Like a monopolist, Burger Bippy may simply equate marginal cost with marginal revenue (see Figure 13.3) and produce Q o units for price P c . Here the oligopolist’s price is significantly above the competitive price level, P c , but not as high as the price charged by a pure monopolist. (If the oligopolist Chapter 13 Imperfect Competition and Firm Strategy 6 were a pure monopoly, it would not have to fear a loss of business to other producers because of a change in price.) Inefficiency in this market is slightly greater than in a monopolistically competitive market—see the shaded triangular area of Figure 13.3. The Oligopolist as Price Leader Alternatively, oligopolists may look to others for leadership in determining prices. One producer may assume price leadership because it has the lowest costs of production; the others will have to follow its lead or be underpriced and run out of the market. The producer that dominates industry sales may assume leadership. Figure 13.4 depicts a situation in which all the firms are relatively small and of equal size, except for one large producer. The small firms’ collective marginal cost curve (minus the large producer’s) is shown in part (a), along with the market demand curve, D m . The dominant producer’s, marginal cost curve, MC d , is shown in part (b) of Figure 13.4. FIGURE 13.4 The Oligopolist as Price Leader The dominant producer who acts as a price leader will attempt to undercut the market price established by small producers (part (a)). At price P 1 the small producers will supply the demand of the entire market, Q 2 . At a lower price—P d or P c —the market will demand more than the small producers can supply. In part (b), the dominant firm determines its demand curve by plotting the quantity it can sell at each price in part (a). Then it determines its profit-maximizing output level, Q d , by equating marginal cost with marginal revenue. It charges the highest price the market will bear for that quantity, P d , forcing the market price down to P d in part (a). The dominant producer sells Q 3 -Q 1 units, and the smaller producers supply the rest. The dominant producer can see from part (a) that at a price of P 1 , the smaller producers will supply the entire market for the product, say, steel. At P 1 the quantity demanded, Q 2 , is exactly what the smaller producers are willing to offer. At P 1 or above, therefore, the dominant producer will sell nothing. At prices below P 1 , however, the total quantity demanded exceeds the total quantity supplied by the smaller producers. For Chapter 13 Imperfect Competition and Firm Strategy 7 example, at a price of P d the total quantity demanded in part (a) is Q 3 , whereas the total quantity supplied is Q 1 . Therefore the dominant producer will conclude that at price Pd, it can sell the difference, Q 3 -Q 1 . For that matter, at every price below P 1 , it can sell the difference between the quantity supplied by the smaller producers and the quantity demanded by the market. As the price falls below P 1 , the gap between supply and demand expands, so that the dominant producer can sell larger and larger quantities. If these are plotted on another graph, they will form the dominant producer’s demand curve, D d (part (b)). Once it has devised its demand curve, the dominant producer can develop its accompanying marginal revenue curve, MR d , also shown in Figure 13.4(b). Using its marginal cost curve, MC d , and its marginal revenue curve, it establishes its profit-maximizing output level and price, Q d and P d . The dominant producer knows that it can charge price P d for quantity Q d , because that price-quantity combination (and all others on curve D d ) represents a shortage not supplied by small producers at a particular price in part (a). Q d , as noted earlier, is the difference between the quantity demanded and the quantity supplied at price P d . So the dominant producer picks its price, P d . And the smaller producers must follow. 3 If they try to charge a higher price, they will not sell all they want to sell. Price Stability and the “Kinked” Demand Curve Several decades ago, economists believed they had noticed something quite significant about oligopolies. For relatively long periods of time, prices in these industries seemed to remain more or less fixed. This observed “stickiness” of oligopolistic prices gave rise to the theory of the “kinked” demand curve—a theory that tries to explain not how prices are determined, but why they do not move very much. Figure 13.5 shows the hypothetical kink in the oligopolist’s demand curve that was thought to produce price stickiness. The notion was that the interdependent nature of oligopolistic pricing decisions gave rise to the kink. Suppose the price of steel is P 1 . An oligopolistic firm can reason that if it lowers its price, other firms will follow suit to protect their shares of the market. Therefore, the demand curve below that point is relatively inelastic. If the firm raises its prices, however, it will lose customers to the other firms, who have no reason to follow a price increase. The demand curve above P 1 is therefore relatively elastic. Because of the kink at P 1 the marginal revenue curve is discontinuous. At an output of Q 1 , a gap develops between the upper and lower portions of the curve (see Figure 13.5). The existence of this gap is easier to understand if one thinks of the kinked demand curve as two separate curves intersecting at the kink. The curve’s bottom half 3 Consider market equilibrium with and without the dominant producer. In the absence of the dominant producer, the market price will be P 1 , the equilibrium price for a market composed of only the smaller producers. The dominant producer adds quantity Q d , which causes the price to fall, forcing the smaller producers to cut back production to Q 1 in part (a). Chapter 13 Imperfect Competition and Firm Strategy 8 _______________________________________________ FIGURE 13.5 The Kinked Demand Curve The theory of the kinked demand curve is based on the questionable premise that an oligopolist’s prices are relatively rigid, or unresponsive to cost increases. According to the theory, the individual oligopolist reasons that other oligopolists will match a price reduction in order to protect their market shares, but will not match a price increase. The individual oligopolist’s demand curve is therefore kinked at the established price: the bottom part is less elastic than the top, where even a small increase in price will cause customers to go elsewhere. Given the kinked demand curve, the firm’s marginal revenue curve will be discontinuous. Even if the oligopolist’s marginal cost curve shifts upward from MC 1 to MC 2 , the firm will not change its price-quantity combination, P 1 Q 2 . belongs to demand curve D 1 in Figure 13.6, and its top half to demand curve D 2 . Seen that way, the two-part marginal revenue curve in Figure 13.5 is simply the composite of the relevant portions of the marginal revenue curves MR 1 and MR 2 in Figure 13.5. At that output level, marginal cost can shift all the way up to MC 2 and the oligopolist will still maximize profits. As long as output remains at Q 2 , the price will remain P 1 . A price increase would not benefit the firm unless its marginal cost curve rose higher than MC 2 – say to MC 3 . In that case the firm’s profit-maximizing price would be only slightly higher, P 2 . ___________________________________________ FIGURE 13.6 The Kinked Demand Curve as Two Separate Curves The oligopolist’s kinked demand curve can be viewed as the composite of two different demand curves. The portion above the kink comes from the top of a demand curve (D 2 ) that is relatively elastic. The portion below the kink comes from the bottom of a demand curve (D 1 ) that is less elastic. Economists at one time thought they had explained the rigidity of oligopolistic prices. The only problem is that further observation has cast doubt on the evidence that motivates the development of the theory. Research conducted over the last three decades Chapter 13 Imperfect Competition and Firm Strategy 9 suggests that prices in industries dominated by a few firms are no stickier than prices in other industries. Because there is some disagreement on the interpretation of the data, the theory remains with us. At best, it is a theory in search of reasonable confirmation. The Oligopolist in the Long Run In an oligopolistic market, significant barriers to entry face new competitors. Firms in oligopolistic industries can therefore retain their short-run positions much longer than can monopolistically competitive firms. Oligopoly is normally associated with the automobile, cigarette, and steel markets, which include some extremely large corporations. There the financial resources required to establish production on a competitive scale may be a formidable barrier to entry. One cannot conclude that all new competition is blocked in an oligopoly, however. Many of the best examples of oligopolies are found in local markets—for instance, drugstore, stereo shops, and lumber stores—in which one, two, or at most a few competitors exist, even though the financial barriers to entry could easily be overcome. Even in the national market, where the financial requirements for entry may be substantial, some large firms have the financial capacity to overcome barriers to entry. If firms in the electric light bulb market exploit their short-run profit opportunities by restricting production and raising prices, outside firms like General Motors Corporation can move into the light bulb market and make a profit. In recent years, General Motors has in fact moved into the market for electronics and robotics. Oligopoly power remains a cause for concern. The basis for competition, however, is the relative ability of firms to enter a market where profits can be made—not the absolute size of the firms in the industry. The small regional markets of a century ago, isolated by lack of transportation and communication, were perhaps less competitive than today’s markets, even if today’s firms are larger in an absolute sense. In the nineteenth century the cost of moving into a faraway market effectively protected many local businesses from the threat of new competition. Cartels: Monopoly through Collusion In either a monopolistically competitive market or an oligopolistic market (or even sometimes in a competitive market), firms may attempt to improve their profits by restricting output and raising their market price. In other words, they may agree to behave as it they were a unified monopoly, an arrangement called a cartel. A cartel is an organization of independent producers intent on thwarting competition among themselves through the joint regulation of market shares, production levels, and prices. The principal purpose of their anticompetitive efforts is to raise their prices and profits above competitive levels. In fact, however, a cartel is not a single unified monopoly, and cartel members would find it very costly to behave as if they were. Incentives to Collude and to Cheat Chapter 13 Imperfect Competition and Firm Strategy 10 The size of monopoly profits provides a real incentive for competitors to collude—to conspire secretly to fix prices, production levels, and market shares. Once they have reduced market supply and raised the price, however, each has an incentive to chisel on the agreement. The individual competitor will be tempted to cut prices in order to expand sales and profits. After all, if competitors are willing to collude for the purpose of improving their own welfare, they will probably also be willing to chisel on cartel rules to enhance their welfare further. The incentive to chisel can eventually cause the demise of the cartel. If a cartel works for long, it is usually because some form of external cost, such as the threat of violence, is imposed on chiselers. 4 Although a small cartel is usually a more workable proposition than a large one, even small groups may not be able to maintain an effective cartel. Consider an oligopoly of only two producers, called a duopoly. A duopoly is an oligopolistic market shared by only two firms. To keep the analysis simple, we will assume that each duopolist has the same cost structure and demand curve. We will also assume a constant marginal cost, which means that marginal cost and average costs are equal and can be represented by one horizontal curve. Figure 13.7 shows the duopolists’ combined marginal cost curve, MC, along with the market demand curve for the good, D. The two producers can maximize monopoly profits if they restrict the total quantity they produce to Q m and sell it for price P m . Dividing the total quantity sold between them, each will sell Q 1 at the monopoly price (2 x Q 1 = Q m ). Each will receive an economic profit equal to the shaded area bounded by ATC 1 P m ab, which is equal to total revenues (P m x Q 1 ) minus total cost (ATC 1 x Q 1 ). ____________________________________ FIGURE 13.7 A Duopoly (Two-Member Cartel) In an industry composed of two firms of equal size, firms may collude to restrict total output to Q m and sell at a price of P m . Having established that price- quantity combination, however, each has an incentive to chisel on the collusive agreement by lowering the price slightly For example, if one firm charges P 1 , it can take the entire market, increasing its sales from Q 1 to Q 2 . If the other firm follows suit to protect its market share, each will get a lower price, and the cartel may collapse. ____________________________________ Once in that position, each firm may reason that by reducing the price slightly say to P 1 and perhaps disguising the price cut through customer rebates or more attractive credit terms, it can capture the entire market and even raise production to Q 2 . 4 A cartel may provide members with some private benefit that can be denied nonmembers. For example, local medical associations can deny nonmembers the right to practice in local hospitals. In that case, the cost of chiseling is exclusion from membership in the group. [...]... volume In the circuit-breaker market, for example, General Electric received 45 percent of the business, Westinghouse 35 percent, Allis -Chalmers 10 percent, and Federal Pacific 10 percent For a more detailed account of this case, see Richard Austin Smith, “The Incredible electrical Conspiracy,” parts I and II, Fortune, April and May 1961, pp 132 ff (April) and pp 161 ff (May) Chapter 13 Imperfect Competition... management Chapter 13 Imperfect Competition and Firm Strategy 24 about the value of the object of the bidding .13 This is no problem when bidding for something the bidder wants for its subjective value (say an antique piece of furniture), since the object probably is worth more to the winning bidder than to others But when bidding for a productive asset (such as an offshore oil field) valued for its ability... Strategy corporate arrangements that provide strong incentives for managers to work together as a team for the good of the shareholders, and that provide them with clear information on how well they are doing These arrangements take many forms, and they are very attractive to managers quite apart from their ability to improve managerial performance For example, few managers complain about executive compensation... hostile takeover attempts (50 of which were successful) from 198 4-1 986 were examined.22 According to this study, layoffs were common, but seldom exceeded 10 percent of the workforce, and were typically far less than that Also, it was estimated that the probability of being laid off was 70 percent higher for white-collar workers than for blue-collar workers The jobs of managers, not those of workers on... associated with the market for corporate control unlocked shareholder gains (in target companies alone) of more than $500 billion between 1977 and 1988 – more than 50% of the cash dividends paid by the entire corporate sector over this same period” [Michael C Jensen, “Eclipse of the Public Corporation,” Harvard Business Review (September-October 1989), pp 6 4-6 5] Chapter 13 Imperfect Competition and... the case of corporations, it is much easier for reporters to obtain information about a corporation from its top managers The fact that there are a multitude of owners in the case of corporations is the basis for other differences between the sale of a house and the sale of a corporation Just as reporters find that it is easier to rely on top management for information on a corporation, so do the owners... Real-World Case of Price Fixing During the 1950s, General Electric Company, Westinghouse Electric Corporation, Allis -Chalmers, Southern States Equipment, and other firms and their executives were accused of conspiring to set prices and divide the market for electrical equipment 1 Their conspiracy, which covered everything from two-dollar insulators to turbine generators, illustrates the incentives for. .. part, the requisite skill at making decisions that benefited the shareholders There is a lot of truth in this justification for high incomes for corporate managers Although it is obviously possible for stock prices to increase or decrease for reasons having nothing to do with the performance of managers, good management decisions do have positive effects on the price of a corporation’s stock But managers... already rich at the expense of the corporation’s average workers (not just its managers), the corporation’s long-run prospects, and the competitiveness of the general economy For example, responding to a hostile takeover bid for Chrysler Corporation by Kirk Kerkorian, a major 22 Chapter 13 Imperfect Competition and Firm Strategy 23 newspaper editorialized, “[W]hen Kerkorian was complaining about insufficient... price one month before the announcement of a takeover bid with the takeover price, and often the price begins increasing in response to rumors long before a formal offer is tendered.11 These percentages represent huge gains in total dollars, amounting to $346 billion over the period 197 7-8 6 (in 1986 dollars), according to one study 12 Those who own something that others are bidding for should be expected . monopolistically. Chapter 13 Imperfect Competition and Firm Strategy 18 Reasons for Takeovers There are many reasons for corporate takeovers and different ways for them to occur competitive firm may deviate little from the price- quantity combination produced under perfect competition. The demand curve for fast- food hamburgers in Figure 13. 1 is highly, although not perfectly,. monopolies. Chapter 13 Imperfect Competition and Firm Strategy 3 __________________________________________ FIGURE 13. 1 Monopolistic Competition in the Short Run Like all profit-maximizing