2015/12/21 Contents Perfect Competitive Market Monopoly Monopolistic Competition Obligopoly Microeconomics Market Structure Chapter By Tran Thi Kieu Minh, MSc ©Kieu Minh, FTU, 2014 The four types of market structure 5.1 Competitive market Perfectly Competitive Markets Profit Maximization Competitive Firm Competitive Market Supply Curve Economists who study industrial organization divide markets into four types: monopoly, oligopoly, monopolistic competition, and perfect competition ©Kieu Minh, FTU, 2014 Producer Surplus ©Kieu Minh, FTU, 2014 2015/12/21 5.1.1 Perfectly Competitive Markets E g.Total, average, & marginal revenue - competitive firm Price Taking The individual firm sells a very small share of the total market output and the individual consumer buys too small a share of industry output, therefore, cannot influence market price o have any impact on market price Price taker Quantity (Q) Price (P) Total revenue (TR=P ˣ Q) Average revenue (AR=TR/Q) Marginal revenue (MR=ΔTR/ΔQ) gallon $6 6 6 6 $6 12 18 24 30 36 42 48 $6 6 6 6 $6 6 6 6 Product Homogeneity The products of all firms are perfect substitutes Free Entry and Exit Buyers can easily switch from one supplier to another Suppliers can easily enter or exit a market ©Kieu Minh, FTU, 2014 The Competitive Firm The Competitive Firm Demand curve faced by an individual firm is a horizontal line at the market price P Price $ per gallon Firm Price $ per gallon Industry S D=AR=MR Firm’s sales have no effect on market price Average revenue = P Marginal revenue = P Profit Maximizing: For a perfectly competitive firm, profit maximizing output occurs when $6 ©Kieu Minh, FTU, 2014 $6 MC (q) MR AR P D 100 200 Output (gallons) ©Kieu Minh, FTU, 2014 100 Output (millions of gallons) ©Kieu Minh, FTU, 2014 2015/12/21 P rofit maximization for a competitive firm Costs and Revenue Ma rginal cost as the competitive firm’s supply curve Price The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue MC MC P2 ATC MC2 ATC P=MR1=MR2 P=AR=MR P1 AVC AVC MC1 Q1 QMAX Q2 ©Kieu Minh, FTU, 2014 5.1.2 Competitive Firm’s Decision Quantity At the quantity Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising production increases profit At the quantity Q2, marginal cost MC2 is above marginal revenue MR2, so reducing production increases profit The profit-maximizing quantity QMAX is found where the horizontal price line intersects the marginal-cost curve Shutdown Short-run decision not to produce anything During a specific period of time Because of current market conditions 10 ©Kieu Minh, FTU, 2014 Quantity ©Kieu Minh, FTU, 2014 The firm’s short-run decision to shut down Shut down if TR ATC ATC AVC If P < ATC .but shuts down if P variable costs Operator of a miniature-golf course Ignore fixed costs Stay open if revenue > variable costs 16 ©Kieu Minh, FTU, 2014 2015/12/21 Competitive Market Supply Curve Quiz1 a b c A competitive Firm ABC has average production cost ($) of 75 ATC q q What is the short-run supply curve of the firm? If market price is $30, what is the optimum quantity of the firm? How much is the maximum profit? What is the firm’s decision if market price decreases to $10? Explain 17 ©Kieu Minh, FTU, 2014 Each firm – supplies quantity where P = MC Market supply For P > AVC: supply curve is MC curve Add up quantity supplied by each firm ©Kieu Minh, FTU, 2014 Quiz (a) Individual firm supply (b) Market supply MC 18 S h ort-run market supply Price Short run: market supply with a fixed number of firms Price Supply A competitive market of a good A has 1000 similar sellers, each has production cost of: TC $2.00 $2.00 1.00 1.00 100 200 Quantity (firm) q 5q Market demand of good A is : Q 20000 500P What is the market supply curve of good A? What is the equilibrium price and quantity? What is the optimum selling quantity of each seller? 100,000 200,000 Quantity (market) In the short run, the number of firms in the market is fixed As a result, the market supply curve, shown in panel (b), reflects the individual firms’ marginal-cost curves, shown in panel (a) Here, in a market of 1,000 firms, the quantity of output supplied to the market is 1,000 times the 19 supplied by each firm ©Kieu Minh, FTU, 2014 quantity 20 ©Kieu Minh, FTU, 2014 2015/12/21 5.1.3 Producer Surplus Producer Surplus for a Firm In the short-run: Price is greater than MC on all but the last unit of output Therefore, surplus is earned on all but the last unit Price ($ per unit of output) The producer surplus is the sum over all units produced of the difference between the market price of the good and the marginal cost of production Area above supply to the market price Producer Surplus MC AVC B A P At q* MC = MR Between and q , MR > MC for all units Producer surplus is area above MC to the price q* 21 ©Kieu Minh, FTU, 2014 22 Producer Surplus for a Market Producer Surplus for a Firm Price ($ per unit of output) Producer Surplus MC Output ©Kieu Minh, FTU, 2014 Price ($ per unit of output) AVC S B A P Market producer surplus is the difference between P* and S from to Q* P* D C q* 24 ©Kieu Minh, FTU, 2014 Producer surplus is also ABCD = Revenue minus variable costs Producer Surplus D Q* Output 25 Output ©Kieu Minh, FTU, 2014 2015/12/21 5.2.1 Monopolist Microeconomics 5.2 Monopoly Monopolist Demand andMarginal Revenue Profit maximization Market power Price discrimination 26 Monopoly resources A key resource required for production is owned by a single firm Higher price Government regulation Government gives a single firm the exclusive right to produce some good or service Government-created monopolies Patent and copyright laws Higher prices; Higher profits 28 ©Kieu Minh, FTU, 2014 Monopoly resources Government regulation The production process ©Kieu Minh, FTU, 2014 Why Monopolies Arise Firm that is the sole seller of a product without close substitutes Price maker Barriers to entry 27 ©Kieu Minh, FTU, 2014 Why Monopolies Arise The production process A single firm can produce output at a lower cost than can a larger number of producers Natural monopoly Arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms 29 Economies of scale over the relevant range of output ©Kieu Minh, FTU, 2014 2015/12/21 Demand and Revenue 6.2.2 Profit maximization A Monopolist’s Demand Curve Price maker Price Sole producer Downward sloping demand Market demand curve: P = f (Q) A monopolist’s revenue Total revenue: TR = Px Q = f (Q) x Q Average revenue: AR = TR/Q Marginal revenue: MR = △TR/△Q = TR’(Q) Can be negative Always: MR < P MR curve – is below the demand curve 30 Demand Q MR ©Kieu Minh, FTU, 2014 31 Monopoly price and then the demand curve shows the price consistent with this quantity Marginal cost B ©Kieu Minh, FTU, 2014 Profit maximization Profit maximization for a monopoly Costs and Revenue Profit maximization If MR > MC – increase production If MC > MR – produce less Maximize profit Produce quantity where MR=MC Intersection of the marginal-revenue curve and the marginal-cost curve Profit maximization Perfect competition: P=MR=MC Monopoly: P>MR=MC The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity Average total cost A Demand Price equals marginal cost Price exceeds marginal cost A monopoly’s profit Profit = TR – TC = (P – ATC) ˣ Q Marginal revenue Quantity Q1 QMAX Q2 A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A) It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B) ©Kieu Minh, FTU, 2014 32 33 ©Kieu Minh, FTU, 2014 2015/12/21 5.2.3 Market Power The monopolist’s profit Costs and Revenue Marginal cost B Monopoly E price L Average total cost Monopoly profit Average total cost P MC P higher numbers implying greater market power Demand D A firm's market power: its ability to price above marginal cost Lerner index, named after the American economist Abba Lerner (1903-1982), was formalized in 1934 For a perfectly competitive firm (where P=MC), L=0; such a firm has no market power C Marginal revenue Quantity QMAX The area of the box BCDE equals the profit of the monopoly firm The height of the box (BC) is price minus average total cost, which equals profit per unit sold The width of the box (DC) is the number of units sold 34 ©Kieu Minh, FTU, 2014 35 ©Kieu Minh, FTU, 2014 6.2.4 The Welfare Cost of Monopolies Monopoly Produce quantity where MC = MR Produces less than the socially efficient quantity of output Charge P>MC The deadweight loss: Triangle between: demand curve and MC curve The inefficiency of monopoly Costs and Revenue Marginal cost Deadweight loss QA Monopoly price DWL ( P MC).dQ Q* Demand Marginal revenue 36 ©Kieu Minh, FTU, 2014 MonopolyEfficient quantity quantity Quantity Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it Thus, the quantity produced and sold by a monopoly is below the socially efficient level The deadweight between demand 37 loss is represented by the area of the triangle ©Kieu Minh,the FTU, 2014 curve (which reflects the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer) 2015/12/21 The Welfare Cost of Monopolies The monopoly’s profit: a social cost? Monopoly Higher profit Not a reduction of economic welfare Bigger producer surplus Smaller consumer surplus Monopoly profit Not a social problem 38 Price discrimination 40 A monopolist has MC = + Q and FC of $1000 He faces the demand of P = 160 – Q (P & C: $/kg, Q : kg) What are the optimum quantity and price of the monopoly? How much is the maximum profit? How much is the consumer surplus created by this monopoly? How much is the DWL? Government places a tax of $4/kg for the product of the monopoly How does profit change? Graph the results ©Kieu Minh, FTU, 2014 5.2.5 Price Discrimination Quiz 39 Perfect First-Degree Price Discrimination Business practice Sell the same good at different prices to different customers Increase profit ©Kieu Minh, FTU, 2014 ©Kieu Minh, FTU, 2014 If the firm can perfectly price discriminate, each consumer is charged exactly what they are willing to pay 41 Additional profit from producing and selling an incremental unit is now the difference between demand and marginal cost ©Kieu Minh, FTU, 2014 10 2015/12/21 Perfect First-Degree Price Discrimination First-Degree Price Discrimination In practice perfect price discrimination is almost never possible Firms can discriminate imperfectly $/Q P max Without price discrimination, output is Q* and price is P* Variable profit is the area between the MC & MR (yellow) Consumer surplus is the area above P* and between and Q* output MC P* With perfect discrimination, firm will choose to produce Q** increasing variable profits to include purple area Can charge a few different prices based on some estimates of reservation prices PC D = AR MR Q* 42 Q** Quantity ©Kieu Minh, FTU, 2014 First-Degree Price Discrimination 43 ©Kieu Minh, FTU, 2014 First-Degree Price Discrimination in Practice Examples of imperfect price discrimination Car salesperson (15% profit margin) Colleges and universities (differences in financial aid) Six prices exist resulting in higher profits With a single price P*4, there are fewer consumers $/Q Lawyers, doctors, accountants P1 P2 P3 MC P* Discriminating up to P6 (competitive price) will increase profits P5 P6 D MR Q* 44 ©Kieu Minh, FTU, 2014 45 Quantity ©Kieu Minh, FTU, 2014 11 2015/12/21 Second-Degree Price Discrimination Second-Degree Price Discrimination In some markets, consumers purchase many units of a good over time $/Q Demand for that good declines with increased consumption Electricity, water, heating fuel Firms can engage in second degree price discrimination P0 Without discrimination: P = P0 and Q = Q0 With second-degree discrimination there are three blocks with prices P1, P2, & P3 Different prices are charged for different quantities or “blocks” of same good P1 P2 AC P3 Practice of charging different prices per unit for different quantities of the same good or service- Block pricing MC D MR Q1 1st Block 46 ©Kieu Minh, FTU, 2014 Third-Degree Price Discrimination Practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group 48 47 Q2 Q3 Quantity 3rd Block ©Kieu Minh, FTU, 2014 Third-Degree Price Discrimination How can the firm decide what to charge each group of consumers? Divides the market into two-groups Each group has its own demand function Examples: airlines, premium v non-premium liquor, discounts to students and senior citizens, frozen v canned vegetables, magazines ©Kieu Minh, FTU, 2014 Q0 2nd Block 49 Total output should be divided between groups so that MR for each group are equal Total output is chosen so that MR for each group of consumers is equal to the MC of production ©Kieu Minh, FTU, 2014 12 2015/12/21 Third-Degree Price Discrimination Algebraically P1: price first group P2: price second group C(QT) = total cost of producing output Profit: Third-Degree Price Discrimination Firm should increase sales to each group until incremental profit from last unit sold is zero Set incremental for sales to group and = QT = Q1 + Q = P1Q1 + P2Q2 - C(QT) Combining these conclusions gives 50 ©Kieu Minh, FTU, 2014 MR1 = MR2 = MC 51 Third-Degree Price Discrimination $/Q First group of consumers:MR1= MC Second group of customers:MR2 = MC ©Kieu Minh, FTU, 2014 Third-Degree Price Discrimination $/Q Consumers are divided into two groups, with separate demand curves for each group MC = MR1 at Q1 and P1 P1 •Q T: MC = MRT •Group 1: more inelastic •Group 2: more elastic •MR1 = MR2 = MCT •Q T control MC MC MRT = MR1 + MR2 P2 D2 = AR2 D2 = AR2 MCT MRT MRT MR2 MR1 52 MR2 D1 = AR1 ©Kieu Minh, FTU, 2014 D1 = AR1 MR1 Quantity 53 Q1 Q Q T ©Kieu Minh, FTU, 2014 Quantity 13 2015/12/21 Other Types of Price Discrimination Intertemporal Price Discrimination Intertemporal Price Discrimination $/Q Practice of separating consumers with different demand functions into different groups by charging different prices at different points in time Initial release of a product, the demand is inelastic Hard back v paperback book New release movie Technology Initially, demand is less elastic resulting in a price of P1 P1 Over time, demand becomes more elastic and price is reduced to appeal to the mass market P2 D2 = AR2 AC = MC MR2 MR1 D1 = AR1 Q1 54 ©Kieu Minh, FTU, 2014 Other Types of Price Discrimination $/Q Practice of charging higher prices during peak periods when capacity constraints cause marginal costs to be higher Rush hour traffic Electricity - late summer afternoons Ski resorts on weekends Movies on weekends MC MR=MC for each group Group has higher demand during peak times P1 Demand for some products may peak at particular times ©Kieu Minh, FTU, 2014 Peak-Load Pricing Peak-Load Pricing Quantity Q2 55 D1 = AR1 P2 MR1 D2 = AR2 MR2 Q2 56 ©Kieu Minh, FTU, 2014 57 Q1 Quantity ©Kieu Minh, FTU, 2014 14 2015/12/21 Competition versus monopoly: A summary comparison Similarities Goal of firms Rule for maximizing Can earn economic profits in short run? Differences Number of firms Marginal revenue Price Produces welfare-maximizing level of output? Entry in long run? Can earn economic profits in long run? Price discrimination possible? 58 Competition Monopoly Maximize profits MR=MC Maximize profits MR=MC Yes Yes Many MR=P P=MC One MRMC Yes Yes No No No No Yes Yes ©Kieu Minh, FTU, 2014 Elasticities of Demand for Brands of Colas and Coffee Many firms 59 ©Kieu Minh, FTU, 2014 5.3.1 Monopolistically Competitive Market 5.3 Monopolistic Competition Not a price – taker Having market power for their own products Free entry and exit Differentiated but highly substitutable products The amount of monopoly power depends on the degree of differentiation Examples of this very common market structure : Toothpaste, Soap Cookies and Cake Instant noodles Fashion 60 ©Kieu Minh, FTU, 2014 61 ©Kieu Minh, FTU, 2014 15 2015/12/21 A Monopolistically Competitive Firm $/Q Short Run MC AC P SR DSR MRSR QSR 62 Downward sloping demand – differentiated product Demand is relatively elastic – good substitutes MR < P Profits are maximized when MR = MC This firm is making economic profits Monopolistic Competition If inefficiency is bad for consumers, should monopolistic competition be regulated? Market power is relatively small Usually there are enough firms to compete with enough substitutability between firms – deadweight loss small Inefficiency is balanced by benefit of increased product diversity – may easily outweigh deadweight loss Quantity ©Kieu Minh, FTU, 2014 63 ©Kieu Minh, FTU, 2014 5.4.1 Oligopoly Market Small number of firms Product differentiation may or may not exist Barriers to entry 5.4 Oligopoly Nash Equilibrium Game Theory Cartel Examples 64 ©Kieu Minh, FTU, 2014 Scale economies Patents Technology Name recognition Strategic action 65 Automobiles Steel Aluminum Petrochemicals Electrical equipment ©Kieu Minh, FTU, 2014 16 2015/12/21 Oligopoly 5.4.2 Oligopoly Equilibrium Management Challenges Strategic actions to deter entry Threaten to decrease price against new competitors by keeping excess capacity Rival behavior Because only a few firms, each must consider how its actions will affect its rivals and in turn how their rivals will react If one firm decides to cut their price, they must consider what the other firms in the industry will Could cut price some, the same amount, or more than firm Could lead to price war and drastic fall in profits for all Actions and reactions are dynamic, evolving over time Defining Equilibrium Nash Equilibrium 66 ©Kieu Minh, FTU, 2014 5.4.3 Competition Versus Collusion: Game Theory Firms are doing the best they can and have no incentive to change their output or price All firms assume competitors are taking rival decisions into account Each firm is doing the best it can given what its competitors are doi 67 ©Kieu Minh, FTU, 2014 Payoff Matrix for Prisoners’ Dilemma The Prisoners’ Dilemma : An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face Two prisoners have been accused of collaborating in a crime They are in separate jail cells and cannot communicate Each has been asked to confess to the crime Prisoner B Confess Prisoner A Don’t confess 68 ©Kieu Minh, FTU, 2014 Don’t confess Confess 69 -5, -5 -1, -10 Would you choose to confess? -10, -1 -2, -2 ©Kieu Minh, FTU, 2014 17 2015/12/21 Oligopolistic Markets Cartels In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur In other oligopoly markets, the firms are very aggressive and collusion is not possible Firms are reluctant to change price because of the likely response of their competitors In this case, prices tend to be relatively rigid Producers in a cartel explicitly agree to cooperate in setting prices and output Typically only a subset of producers are part of the cartel and others benefit from the choices of the cartel If demand is sufficiently inelastic and cartel is enforceable, prices may be well above competitive levels Conclusions Collusion will lead to greater profits Explicit and implicit collusion is possible Once collusion exists, the profit motive to break and lower price is significant 70 ©Kieu Minh, FTU, 2014 71 ©Kieu Minh, FTU, 2014 Cartels Examples of successful cartels OPEC International Bauxite Association Mercurio Europeo Examples of unsuccessful cartels 72 Copper Tin Coffee Tea Cocoa ©Kieu Minh, FTU, 2014 18 ... Peak-Load Pricing Peak-Load Pricing Quantity Q2 55 D1 = AR1 P2 MR1 D2 = AR2 MR2 Q2 56 ©Kieu Minh, FTU, 2 014 57 Q1 Quantity ©Kieu Minh, FTU, 2 014 14 20 15 / 12 / 21 Competition versus monopoly: A summary... Minh, FTU, 2 014 Don’t confess Confess 69 -5, -5 -1, -10 Would you choose to confess? -10 , -1 -2, -2 ©Kieu Minh, FTU, 2 014 17 20 15 / 12 / 21 Oligopolistic Markets Cartels In some oligopoly markets, pricing... in a market of 1, 000 firms, the quantity of output supplied to the market is 1, 000 times the 19 supplied by each firm ©Kieu Minh, FTU, 2 014 quantity 20 ©Kieu Minh, FTU, 2 014 20 15 / 12 / 21 5. 1. 3 Producer
