Reading 16 LOS's

Question 1

LOS 16a: Describe characteristics of perfect competition

LOS 16b: Explain the relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under perfect

LOS 16c: Describe a firm’s supply function under perfect

LOS 16d: Describe and determine the optimal price and output for firms under perfect competition

LOS 16e: Explain factors affecting long-run equilibrium under perfect

LOS 16f: Describe pricing strategy under perfect

LOS 16h: Identify the type of market structure within which a firm operates.

Answer 1

Perfect Competition

Characteristics

• Larger number of buyers and sellers
• each seller offers an identical product for sale
• there are minimal barriers to entry
• sellers have no pricing power
• there is no nonprice competition in the market

Demand in Perfect Competition

The market demand curve is downward sloping.

• P= 20 -.5Q

Total Revenue equals Price times Quantity

• TR= PQ= (20 -.5Q) Q = 20Q - .5Q²

Average revenue is total divided by quantity:

• AR= TR/ Q = (20Q -.5Q²) /Q = 20-.5Q

Notice that the Average Revenue curve is the same as the demand Curve

Marginal Revenue is the change in total revenue brought about by selling an additional unit of output:

• MR = Change in TR/ Change in Q = 20 - Q

Price Elasticity of Demand

Greater than 1 is elastic, less than 1 is inelastic, and 1 is unit elastic

• Will be higher if there are close substitutes
• Will be higher if a greater share of the consumer’s income is spent on good
• will be higher in the long-run
• is higher at higher prices on the demand curve

Price Elasticity, Marginal Revenue, and Total Revenue

• If E_p> 1 ==> Demand is elastic — If P increases makes TR decrease and if P decreases makes TR increase
• If E_p= 1 demand in unit elastic ==> change in P will have no change in TR
• If E_p< 1 ==> demand inelastic – If P increase then TR increase and if P decreases then TR decreases

If a company is operating in the inelastic proportion of the demand curve increasing price would result in an increase in total revenue.

If a company is operating in the elastic proportion of the demand curve, decreasing price would result in an increase in total revenue

The relationship between MR and price elasticity can be expressed as:

• MR = P [1 - (1/E_p)]

If producers know the price and price elasticities of demand for different products, they can use the relationship defined in the equation above to determine marginal revenue and use the infromation to decide which product to supply. The higher the price and MR of a product, the greater the incentive to supply that particular product

Supply Analysis in Perfectly Cometitive Markets

• As prices increase, firms are willing and able to supply greater quantities of the product
• Economic profit equals total revenue minus explicit and implicit costs
• Accounting profit does not account for opportunity (implicit) costs).

Optimal Price and Output in Perfectly Competitive Markets

equilibrium price and output are determined at the intersection point of the market demand and supply curves.

Each firm in perfect competition is very small compared to the size of the overall market.

• Demand curve faced by firms is perfectly elastic (horizontal)
• A firm will not sell any output if it raises its prices above the equilibrium market price
• A firm would not be willing to sell its output at a price lower than the market price

Average Reveneu will equal price which will equal marginal revenue (AR = P = MR)

The law of diminishing marginal returns dictates the “U” shape of SR costs curves.

Firms always max profits at the point where MC =MR

In the Short-Run a firm can make economic profits, losses, or normal profit

• If P>AC = economic profit
• If P = AC = normal profit
• If P < AC = economic loss

In the long run all firms in perfect competition will only make normal profit.

• in the long run MC = MR = P = min AC

Changes in Plant Size

In perfect competition, firms that are not operating at their minimum short-run average cost can make profits by increasing plant size. they can do this until they are operating on the minimum point on the SRAC curve whos point coincides with the minimum point of the LRAC curve. There is no point in expanding beyond this size, as diseconomies of scale would set in and actually increase the firms average costs.

Conclusion A firm might increase plant size to reduce average costs and realize economic profits, but its ability to do so will be limited because as more firms increase their plant sizes, industry supply will increase and prices will fall to the level where they equal the firm’s new minimum average cost

Permanent Decrease in Demand for a Product

A reduction in demand results in lower prices. Perfectly competitive firms that were previously making normal profit, will now suffer economic losses. Lower prices will cause each firm to reduce output.

Economic losses prompt some firms to exit the industry. Their exit reduces market supply and boosts prices for all remaining firms back to equilibrium, letting them earn normal economic profits

Schumpeter’s Take on Perfect Competition

He suggest that perfect competition is more of a long-run type of market structure. In the short run, companies develop new products or processess that give them an edge over competitors. During this period, innovative firms see their profits soar. However over the long run, other companies will copy its idea, giving no company an edge, and restoring perfect competition

Question 2

LOS 16a: Describe characteristics of monopoly

LOS 16b: Explain the relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under monopoly

LOS 16c: Describe a firm’s supply function under monopoly

LOS 16d: Describe and determine the optimal price and output for firms under monopoly

LOS 16e: Explain factors affecting long-run equilibrium under monopoly

LOS 16f: Describe pricing strategy under monopoly

LOS 16h: Identify the type of market structure within which a firm operates.

Answer 2

Monopoly

Characteristics

• There is a single seller of highly differentiated product, which has no close substitutes
• There are high barriers to entry
• The firm has considerable pricing power
• The product is differentiated through nonprice strategies (advertising)

Factors that give Rise to Monopolies

• Control over critical sources of production
• Patents or copyrights
• Nonprice differentiation leading to pricing-power
• Network effects, which result from synergies related to increasing market penetration ( no need to train people on Word, everyone knows how to use it)
• Government-controlled authorization

Demand Analysis in Monopoly Markets

The demand curve faced by monopoly is effectively the industry demand curve. It is downward sloping

• the AR curve is the same as the demand curve
• The MR curve and demand curve have the same y-intercept
• the slope of the MR curve is two times the slope of the demand curve
• The x-intercept of the MR curve is half of that of the demand curve
• The MR curve is the derivative of the TR curve with respect to quantity sold

Supply Analysis in Monopoly Markets

• The monopolists does not have a well-defined supply function that determines optimal price and output
• THe profit-maximizing output level occurs at the point where MR = MC
• the price is determined from the demand curve

Optimal Price and Output in Monopoly Markets

The profit-maximizing output level equals the quantity at which:

• MC = MR
• Profit is unaffected by changes in quantity

The profit max level of output always occurs in the relatively elastic portion of the demand curve. This is because MC and MR will always intersect where MR is positive. We stated the relationship between them as:

• MR = P [1 - (1/E_P)]

in a monopoly MC= MR so:

• P [1 - (1/E_P)] = MC

The monopoly can use this relationship to determine the profit-maximizing price if it knows its cost structure and price elasticity of demand

Natural Monopoly

This is an industry where the supplier’s average cost is still falling, even when it satisfies total market demand entirely on its own. A natural monopoly will have high fixed costs, but low and relatively constant marginal costs. If two firms were sharing the market, each would produce a lower output and incur higher average costs. Therefore, governments allow only one firm to continue to dominate the industry and find it more effective to regulate it. (example is Power distribution company)

Regulation of Natural Monopolies

Efficient Regulation is when the government forces the monopoly to charge a price equal to its marginal cost. At this point the entire surplus would go to consumers, as they benefit from lower prices and increase output. However at this point the monopoly will suffer economic losses. If they government doesn’t want to change the price restriction, it will have to offer the monopoly subsidies or tax breaks to stay in business.

Another option is to restrict prices to average costs. In this situation the monopolists makes a normal profit and is not tempted to exit the industry

Price Discrimination and Consumer Surplus

First Degree Price Discrimination occurs when a monopolist is able to charge each individual consumer the highest price they are willing to pay. If they can keep consumers separated, so they don’t know how much each one is paying, then the monopolists can overcharge consumers.

• Under perfect price discrimination the monopolists is able to take away all consumer surplus, and charge each consumer the maximum they are willing to pay for the product

Second Degree Price Discrimination the monopolists uses the quantity purchased to determine whether the consumer values the product highly( and is therefore willing to pay a higher price for larger quantities) or not so highly (and is therefore only willing to pay the lower price for the small quantity). THe monopolists would then sell small quantities at the marginal price and large quantities at a higher price

Third Degree Price Discrimination can occur when customers can be separated by geographical or other traits. One set of customers is charged a higher price, while the other is charged a lower price (adult haircut vs child haircut)

Factors Affecting Long Run Equilibrium in Monopoly Markets

An unregulated monopoly can earn economic profits in the long run as it is protected by substantial barriers to entry.

For regulated monopolies such as natural monopolies, there are various solutions:

• A marginal cost pricing structure. However, the firm must be provided a subsidy in this scenario
• An average cost pricing structure
• National Ownership of the monopoly
• Franchising the monopoly via a bidding war

Question 3

LOS 16a: Describe characteristics of monopolistic competition

LOS 16b: Explain the relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under monopolistic

LOS 16c: Describe a firm’s supply function under monopolistic

LOS 16d: Describe and determine the optimal price and output for firms under monopolistic

LOS 16e: Explain factors affecting long-run equilibrium under monopolistic

LOS 16f: Describe pricing strategy under monopolisitc

LOS 16h: Identify the type of market structure within which a firm operates.

Answer 3

Monopolistic Competition

Characteristics

• There are a large number of buyers and sellers
• The products offered by each seller are similar, but not identical. They serve as close substitutes to each other
• Firms try to differentiate their product from the competition through advertising and other nonprice strategies
• There are low barriers to entry and exit
• Firms have some degree of pricing power

A firm can establish significant pricing power in monopolistic competition if it is able to build brand loyalty

Demand and Supply Analysis in Monopolistically Competitve Markets

Demand:

• Each firm faces a downward-sloping demand curve
• Demand is relatively elastic at higher prices and relatively inelastic at lower prices

Supply:

• There is no well-define supply function
• Neither MC nor the AC curve represent the firm’s supply curve
• The firm will always produce at the output level where MC=MR
• The price that is charged is derived from the market demand curve

In the short-run monopolistic competition will make its price and output decision just like a monopoly and produce where MC = MR. The difference between the two is what happens in the long-run

Factors Affecting Long-Run Equilibirum in Monopolisitcally Competitive Markets

If firms in monopolistic competition are making economic profits in the short run, new firms will move into the industry. Due to low barriers, new firms will be able to capture some market share in the industry. This will reduce demand till where it is tangent with AC curve

If there are economic losses in the short run, some firms will exit. This will result in increased demand for the remaining companies. Eventuall normal profits will be made

Monopolistic Competition vs Perfect Competition

A firm in monopolistic generally produces lower output and charges a higher price than a firm in perfect. This means that outcome is not allocatively efficient (recall allocative efficiency is reached when P = MC, which occurs in perfect).

In the long run, both monopolistic and perfect produce where MR = MC. The difference is that in monopolistic, the average cost are still falling, while in perfect they are at there minimum or the efficient scale of production. This means monopolistic have excess capacity.

Question 4

LOS 16a: Describe characteristics of oligopoly

LOS 16b: Explain the relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under oligopoly

LOS 16c: Describe a firm’s supply function under oligopoly

LOS 16d: Describe and determine the optimal price and output for firms under oligopoly

LOS 16e: Explain factors affecting long-run equilibrium under oligopoly

LOS 16f: Describe pricing strategy under oligopoly

LOS 16h: Identify the type of market structure within which a firm operates.

Answer 4

Oligopoly

Characteristics

• There are a small number of sellers
• The products offered by sellers are close substitutes for each other. Products can be differentiated by brand (Pepsi vs Coke) or be homogenous (oil)
• There are high costs of entry and significant barriers to competition
• Firms enjoy substantial pricing power
• Products are often differentiated on the basis of quality, features, marketing, and other nonprice strategies

Since there are so few firms there is an incentive for price collusion to increase profits.

Demand Analysis and Pricing Strategies in Oligopoly Markets

There are three basic pricing strategies in oligopoly markets

1. Pricing interdependence (kinked demand curve model) is when there are “price wars” between the firms in the industry. The kinked demand curve model assumes that if a firm operating in an oligopoly increases its price, others will not follow suit so the firm will suffer a large decrease in quantity demanded. However if the firm were to reduce its price, competitors would follow its lead, and the increase in quantity demanded for the firm would not be significant. The two constrasting shapes of the demand curve result in a kink in the firms demand curve and a break in its marginal revenue curve. This explains why stable prices have been seen in oligopoly markets, but does not explain how the original price was determined.
2. The Cournot assumption, asserts that each firm determines its profit-max level assuming that other firms’ output will not change. In equilibrium, no firm has an incentive to change output. In the long run, prices and output are stable– there is no possible change in output or price that would make any firm better off. This solution falls between competitive and monopoly equilibrium. As the number of firms in the industry increases, industry equilibrium approaches competitive equilibrium
   
   • Let us consider an example between two firms that face constant MC of $40
   • Take market demand curve Q= 400 - P
   • State it in terms of market price P = 400 - q1 - q2 (where q1 and q2 are the quantities produced by the two firms)
   • Their total revenue will look like
     
     • TR₁= PxQ= (400-q₁-q₂)q₁= 400q₁ - q₁²-q₁q₂
     • TR₂= 400q₂ -q₁q₂- q₂²
   • The Marginal revenue is the derivative of TR with repect to quantity
     
     • MR₁= 400 -2q₁- q₂
     • MR₂ = 400 - q₁ -2q₂
   • Both firms will look to max profits when MC = MR. Since both have constant MC of $40, we can solve for q₁ by:
     
     • 400 - 2q₁ - q₁ = 40.
   • This will lead to 120 for both firms and then using the price earlier
     
     • P = 400 - q₁ -q₂= 400 - 240 = $160
3. Game Theory (Nash Equilibrium) is achieved when none of the firms in an oligopoly market can increase profits by unilaterally changing its price. each firm tries to maximize its own profits given the repsonses of its rivals. Each firm anticipates how its rival will respond to a change in its strategy and tries to maximize its profits under the forecasted scenario. As a result, the firms in the market are interdependent, but their actions are noncooperative. Pretty much it will be a box going over 4 situations involving the company and its rival charging high prices and low prices. Maximum joint profit will occur when both firms charge the high price.

Factors Affecting Chances of Successful Collusion

• There are fewer firms in the industry or if one firm is dominant
• The firms produce similar products
• The firms have similar cost structures
• Order size is small and orders are received more frequently
• There is minimal threat of retaliation from other firms in the industry
• There is minimal external competition

Supply Analysis in Oligopoly Markets

• The supply function for a firm in an oligopoly is not well defined because optimal quantity and price depend on the actions of rival firms
• The firms produces where MC =MR
• Equilibrium price comes from the demand curve

Optimal Price and Output in Oligopoly Markets

There is no single optimal price and output

• In the kinked demand curve, optimal price is the prevailing price
• In the dominant firm model, the leader produces an output level where MC = MR
• In the Cournot’s assumption, each firm assumes that rivals will have no response to any actions on their part. Each firm produces at MC = MR
• In a Nash equilibrium, firms continue to repsond to changin circumstances with the aim of maximizing thier own profits.

Factors Affecting Long-Run Equilibrium in Oligopoly Markets

Firms in oligopolies can make economic profits in the long run. Sometimes, as more firms enter the industry in the long run, they can displace the dominant firm over time. In the long run, optimal pricing decisions must be made in light of the reactions of rivals

Question 5

LOS 16g: Describe the use and limitations of concentration measures in identifying market structure

Answer 5

Econometric Approaches

Estimate the price elasticity of market demand

• If demand is relatively elastic, the market is probably close to perfect comp
• IF demand is relatively inelastic, supplying firms may enjoy pricing power

Limitations:

• Problem of endogeneity: Observed prices and quantities are equilibrium prices and quantities. The entire demand and supply curve cannot be observed and therefore must be estimated

Time-series analysis

• Compute price elasticity using historical sales and market price data

Limitations

• A large number of observations is required
• There is always the possibility that the market structure and elasticities have changed over the sample period

Cross-Sectional Regression Analysis

• Examine sales made by different companies in the market over a specific period
• Look at single transactions from different buyers

Limitations

• It is very complicated
• Obtaining the data can be difficult

Other Measures:

N-Firm Concentration ratio - Simply computes the aggregate market share of the N largest firms in the industry. The ratio will equal 0 for perfect comp and 100 for monopoly.

Herfindahl- Hirschman Index (HHI) Adds up the squares of the market shares of each of the largest N companies in the market. The HHI equals 1 for monopolu. If there are M firms in the industry with equal share, the HHI will equal 1/ M