Lecture Managerial economics - Chapter 4: Four possible markets

Lecture Managerial economics - Chapter 4 presents four possible markets: Perfect Competition (price-takers), monopolistic Competition (price-searchers), oligopoly (a few firms dominate), monopoly (single seller).

WEEK FOUR POSSIBLE MARKETS Perfect Competition (price-takers) Monopolistic Competition (price-searchers) Oligopoly (a few firms dominate) Monopoly (single seller) PERFECT COMPETITION Many firms in the industry and no barriers to entry (exit)  We learned that competitive market is the best for the society  PS+CS is maximized  COMPETITIVE EQUILIBRIUM Perfect Competition market 1.Large market with many firms and consumers No barriers to entry (exit) All firms produce an identical, homogenous, standardized product Firms are “price takers” (the market price is given) Consumers are also price takers Output rule: MR = MC to max profits Social efficiency PRICE FOR A COMPETITIVE FIRM  A competitive firm can keep increasing its output without affecting the market price  So, each one-unit increase in Q causes revenue to rise by P, i.e., MR= P  MR= P is only true for firms in competitive markets MC & THE FIRM’S SUPPLY DECISION MR= MC at the profit-maximizing Q  At Qa, MC< MR So, increase Q to raise profit  At Qb, MC> MR So, reduce Q to raise profit  At Q1, MC= MR Changing Q would lower profit  Rule: SHUTDOWN VS EXIT A short-run decision not to produce anything because of market conditions  Exit: A long-run decision to leave the market  A firm that shuts down temporarily must still pay its fixed costs A firm that exits the market does not have to pay any costs at all, fixed or variable  Shutdown: A FIRM’S SHORT RUN DECISION TO SHUT DOWN  If firm shuts down temporarily, revenue falls by TR  costs fall by VC  So, the firm should shut down if TR< VC TR/Q< VC/Q  So we can write the firm’s decision as: Shut down if P< AVC  A FIRM’S LONG RUN DECISION TO EXIT  If firm exits the market, revenue falls by TR  costs fall by TC   So, the firm should shut down if TR< TC  So we can write the firm’s decision as: Exit if P< ATC or Enter if P>ATC EXAMPLE: AIRLINE REGULATION The regulations in airline industry in 1970s were restricted entry and set fares higher the free market prices? The effect of deregulation: the # of carriers increased dramatically The government imposing the price control in the first place was to provide “stability” in an industry that was considered vital to the U.S economy AIRLINE REGULATION The airfare was regulated at P_min CS = A , PS = B+C  Deregulation (free market) CS = A+B+D, PS =C+E Which is better for economy?  10 EX HIGHER EDUCATION: POSITIVE EXTERNALITY 25 POLITICAL ECONOMY: FIXING EXTERNALITIES Subsidy (for positive externality) • Education subsidy Regulation (for negative externality) • Fees (Emission fees, Penalties, Taxes) • Standard (emissions limits; building codes) Ownership • New idea • Creates a market for externality by giving ownership to one party • Let market solve the externality – Ex sellable pollution permits (give ownership to factory or to neighbors) – Case “Buying and Selling the Right to Emit Nitrogen Oxides” • Potential problem: – Sometimes hard to define the ownership of the externality (ex Higher26 education) DISCUSSION: NETWORK (POSITIVE) EXTERNALITY Let’s think externality from the business perspective Positive externality exists for word processors For example, if people use more MS Word software, it will give more benefits to the Word users because they can share the same file format • This type of positive externality is also known as network externality If you are Bill Gates, what would you do? 27 SUMMARY Market Failure • Free market may not be the best for the society • Principle #5 fails Public Goods • Can’t exclude one’s consumption • Private firms will not provide the goods • Government should step in Externality • Free market will not reflect the real cost/benefit to the overall society • Market will not produce optimal quantity • How to fix it? 28 PREVIEW So far we have analyzed competitive markets • assumed there are many sellers and buyers • but in reality, many markets have a small number of big sellers (monopoly, oligopoly) We will study monopoly and oligopoly • many strategic implications –How to price –Where to position 29 MONOPOLY Pure Monopoly: Market with a single supplier Near Monopoly: Market where a single firm, or several firms, has (have) 90% or more of the “market” Cartel: A group of firms that act as monopolist Problems: Monopoly power leads to a single dominant firm An extremely efficient firm becomes industry leader e.g Alcoa 30 MONOPOLY What are the choice variables for the monopoly? • Price • Quantity • Quality • etc • We will focus on P & Q only and ignore other variables Objective of monopoly? • Maximize its own profits 31 IMPORTANT MONOPOLY RESULTS Monopoly price is higher than competitive market price Monopoly quantity will be smaller than competitive market quantity CS (=A) is going to be smaller than competitive market CS (A+B+C) PS (=B+D) is highest Total surplus (CS+PS = A+B+D) is smaller than that of competitive market (CS+PS = A+B+C+D+E) 32 MONOPOLY & SOCIAL LOSS Social Loss Total surplus (CS+PS) is smaller than competitive market Because of this social loss, monopoly is often regulated by antitrust laws in U.S., monopoly is not illegal, but exercising monopoly power is illegal –Price gouging –Predatory pricing (killing competitors) Lessons for business managers: • Try to become a monopoly but don’t exercise the monopoly power! 33 HOW TO BECOME A MONOPOLY No substitutes • uniqueness of the product, • limited market boundary Barriers to entry • government regulation • patents • slack capacity / sunk costs • network externality • Principle #6 Economies of scale • occurs if large fixed costs / very low variable costs • e.g Verizon local phone service Cartel • e.g OPEC 34 BARRIERS TO ENTRY Economies of scale:  New firms may have to enter at a large scale to be competitive (Motor vehicles)  You cannot start small and grow big (Wal-mart, McDonald’s), you have to start big Large capital requirements or sunk cost Pure quality and cost advantages Product differentiation Control of resources (DeBeers -90% of world diamond, OPEC-40% world oil) Patents, Copyrights, Trademarks, Intellectual Property Rights 35 NATURAL MONOPOLIES When the average total cost declines over the entire range of market demand, it might be efficient and “natural” to have only one producer e.g Public utilities like water, electricity, natural gas, cable TV The state, federal, or local governments regulate and control the natural monopolist Regulation solution: forcing the natural monopolist to set up the pricing policy: average-cost pricing P = Average Total Cost Average-cost pricing is s significant improvement over pure monopoly outcome 36 PROBLEMS WITH AVERAGE-COST PRICING It might be difficult and time-consuming to accurately determine the natural monopolist's true ATC to determine rates The utility would have an incentive to exaggerate its costs to try to justify a rate increase Natural monopoly has no incentive to keep costs down and operate efficiently if all increases in ATC are exactly offset by a higher rate In general, (not solely related to average-cost pricing) regulators may maintain the status quo, protect the public utility or regulated industry and prevent competition, resulting in higher prices and less overall competition 37 SUMMARY OF MONOPOLY Monopoly is not good for the society • High price & low quantity • Small CS • maximum PS (good for the company) Sources of Monopoly • Business Strategy: develop these sources to increase monopoly status 38 SUMMARY OF MONOPOLY (CONTINUED) Monopoly • High price, low quantity • Best scenario for the business • Worst scenario for the consumers • Pricing Strategy –Try to convert consumer surplus into producer surplus • Business Strategy –Try to keep the monopoly status LEGALLY! 39 ... So, each one-unit increase in Q causes revenue to rise by P, i.e., MR= P  MR= P is only true for firms in competitive markets MC & THE FIRM’S SUPPLY DECISION MR= MC at the profit-maximizing... Changing Q would lower profit  Rule: SHUTDOWN VS EXIT A short-run decision not to produce anything because of market conditions  Exit: A long-run decision to leave the market  A firm that shuts down... telecommunication industry in 1996 - the first major change to telecommunications law in the United States in over 64 years – the Telecommunications Act of 1996, P.L 9810 4-1 04, 110 Stat 56 (1996) Gas