1. ECON 2001 Microeconomics II 2014 2 nd semester Elliott Fan Economics, NTU Lecture 3 Microeconomics, 2014-2 Elliott Fan Lecture 3

2. Elliott Fan: Micro 2014-2 Lecture 2 Market Power, Collusion, and Oligopoly Chapter 11 Price Theory Slide 2

3. Elliott Fan: Micro 2014-2 Lecture 2 Acquiring Market Power Mergers – Horizontal integration – Vertical integration Antitrust policies Predatory pricing Resale price maintenance (RPM) Slide 3

4. Elliott Fan: Micro 2014-2 Lecture 2 Mergers Horizontal integration – Produce same good merge Ex. Dell, Gateway, and IBM Vertical integration – Merge so produce inputs used to produce output Ex. Dell and Intel Slide 4

5. Elliott Fan: Micro 2014-2 Lecture 2 Horizontal Integration Reasons to merge – Isolate economies of scale and capture monopoly power Competing welfare concerns – Reducing costs and creating monopoly power Ex. Great American Merger Wave Slide 5

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7. Elliott Fan: Micro 2014-2 Lecture 2 Welfare implications Consumers – Can be good or bad for consumers – Depends specifics of market structure Small firms – Can be good for small firms not involved in the merger if the merging results in a higher product price. – Can be bad if merging results in higher efficiency (ie, lower MC) Slide 7

8. Antitrust Policies Sherman Act of 1890 Clayton Act of 1914 Prevent mergers tend to reduce competition Controversy over antitrust criteria – Economic efficiency – US Supreme Court versus European antitrust position 8

9. Elliott Fan: Micro 2014-2 Lecture 2 Vertical Integration Two monopolist merge – Eliminate monopoly power – Benefit consumers (why?) – Increase total surplus after merger Other types of vertical integration – Good or bad – Depends specifics of market structure – Shapes of demand and cost curves Slide 9

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11. Elliott Fan: Micro 2014-2 Lecture 2 Predatory Pricing Damage rival firms – Sets prices artificially low Skepticism about use in marketplace – Difficult to define – Unlikely to last long, if adopted, because of negative profit – Competitors re-emerge once the PP is over – The “prey” companies are not always vulnerable Slide 11

12. Elliott Fan: Micro 2014-2 Lecture 2 Resale Price Maintenance (RPM) Producer – Set retail price and forbid any retailer to sell at discount Benefits according to the retail service argument: – Wholesaler – better off (larger sale) – Retailer – better off or unchanged – Consumer – better off (CS is larger) Prices or service kept high if the value added by retailers is sufficiently large Slide 12

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14. Elliott Fan: Micro 2014-2 Lecture 2 Resale Price Maintenance This retail service argument does not always hold. RPM is prohibited in the US and in Taiwan, however, RPM remains a common practice in Taiwan.Taiwan Slide 14

15. Elliott Fan: Micro 2014-2 Lecture 2 Resale Price Maintenance Question: does the retail service argument apply to the issue of online bookstores (such as books.com.tw) and physical bookstores so gain your support for RPM in this case? News about bookstores: 1.Subsidy for small bookstoresSubsidy for small bookstores 2.Tax deduction for physical bookstroresTax deduction for physical bookstrores Slide 15

16. Elliott Fan: Micro 2014-2 Lecture 2 Oligopoly An industry in which individual firms can influence market conditions. We begin with introducing three different models of oligopoly. Slide 16

17. Elliott Fan: Micro 2014-2 Lecture 2 Fixed Number of Firms Stackelberg model Cournot model – Take rivals output as given – Production level Bertrand model – Take rivals prices as given – MC and pricing move toward competition Slide 17

18. Elliott Fan: Micro 2014-2 Lecture 2 The first model is the Stackelberg model, for instance, IBM and its follower. It is a quantity setting game and 1 is the leader who chooses to produce y 1 while after seeing that, the follower, 2 decides to produce y 2. The total output of the market is therefore y 1 +y 2 and the price is p(y 1 +y 2 ). (sequential) Slide 18

19. Elliott Fan: Micro 2014-2 Lecture 2 Solving backwards, follower’s problem max y 2 p(y 1 +y 2 )y 2 -c 2 (y 2 ). FOC: p(y 1 +y 2 )+p’(y 1 +y 2 )y 2 =c 2 ’(y 2 ). So basically, from FOC, we can derive the reaction function of 2. That is, given y 1, there is an optimal level of y 2. In the following we will work with the case where p(Y)=a-bY and c 2 (y 2 )=0 for all y 2.  2 =(a-b(y 1 +y 2 ))y 2 =ay 2 -by 1 y 2 -by 2 2 and FOC: a-by 1 -2by 2 =0 or y 2 =(a-by 1 )/2b (reaction function). Slide 19

20. Elliott Fan: Micro 2014-2 Lecture 2 Two points worth mentioning. When y 1 =a/b (1 has flooded the market), then y 2 =0. On the other hand, when y 1 =0, it is as if 2 is the monopolist, so y 2 =a/2b. Let us suppose c 1 (y 1 )=0 for all y 1 and work out the leader’s problem: max y 1 p(y 1 +y 2 )y 1 -c 1 (y 1 ). Now, we can plug in 2’s reaction curve. So  1 =(a-b(y 1 +(a- by 1 )/2b))y 1 =(a-by 1 )y 1 /2. FOC: a/2-by 1 =0 So y 1 =a/2b. Slide 20

21. Elliott Fan: Micro 2014-2 Lecture 2 Plugging this into 2’s reaction curve, we get y 2 =(a-b(a/2b))/2b=a/4b. Show this graphically. Now turn to the Cournot model. Two firms simultaneously decide output levels. We look for the case where 1’s output is a best response to 2’s and vice versa 2’s is a best response to 1’s. Graphically, it is the intersection of the two reaction curves. Slide 21

22. Fig. 27.2 22

23. Elliott Fan: Micro 2014-2 Lecture 2 Since y 2 =(a-by 1 )/2b and symmetrically y 1 =(a-by 2 )/2b, solving these two together, we get y 1 =y 2 =a/3b. Suppose the two quantity setting firms get together and attempt to set outputs so that their joint profit is maximized, i.e., they collude or form a cartel, what will the output levels be? Their problem becomes max y 1,y 2 (a- b(y 1 +y 2 ))(y 1 +y 2 ). FOC: y 1 +y 2 =a/2b. Slide 23

24. Fig. 27.4 24

25. Elliott Fan: Micro 2014-2 Lecture 2 Bertrand model It is a model of price competition between duopoly firms which results in each charging the price that would be charged under perfect competition, known as marginal cost pricing. Slide 25

26. Elliott Fan: Micro 2014-2 Lecture 2 Bertrand model Assumptions: There are at least two firms producing homogeneous products; Firms do not cooperate; Firms have the same marginal cost (MC); Marginal cost is constant; Demand is linear; Firms compete in price, and choose their respective prices simultaneously; Slide 26

27. Elliott Fan: Micro 2014-2 Lecture 2 Bertrand model There is strategic behavior by both firms: Both firms compete solely on price and then supply the quantity demanded; Consumers buy everything from the cheaper firm or half at each, if the price is equal. Competing in price means that firms can easily change the quantity they supply, but once they have chosen a certain price, it is very hard, if not impossible, to change it, for example bars or shops or other companies that publish non-negotiable prices. Slide 27

28. Elliott Fan: Micro 2014-2 Lecture 2Slide 28

29. Elliott Fan: Micro 2014-2 Lecture 2 Bertrand model vs cournot model Although both models have similar assumptions, both have very different implications. Bertrand predicts a duopoly is enough to push prices down to marginal cost level, that duopoly will result in perfect competition. Neither model is necessarily "better". If capacity and output can be easily changed, Bertrand is generally a better model of duopoly competition. Or, if output and capacity are difficult to adjust, then Cournot is generally a better model. Can you provide any example? Slide 29

30. Elliott Fan: Micro 2014-2 Lecture 2 Other market structures Many researchers are unsatisfied with these oligopoly models, as needed assumptions are to some extent unrealistic. Other models are developed: – Contestable market – Monopolistic competition – Game Slide 30

31. Elliott Fan: Micro 2014-2 Lecture 2 Contestable Markets Firms enter and exit costlessly (This is the focus of this model) – Airline market as a typical example Assume identical firms – If AC curves cross industry demand in upward-sloping region Price, AC, MC all equal Slide 31

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33. Elliott Fan: Micro 2014-2 Lecture 2 Contestable Markets Why is this model interesting? Realistic -- It describes markets served by a small number of firms, which are nevertheless characterized by competitive equilibria. The theory of contestable markets has been used to argue for weaker application of antitrust laws, as simply observing a monopoly market may not prove that a firm is exploiting its market power to control the price level. Slide 33

34. Elliott Fan: Micro 2014-2 Lecture 2 Monopolistic Competition Market where there are many similar but differentiated products. Similar products remain close substitutes. Thus, the demand curve facing an firm is downward sloping, but relatively flat (elastic). Entry is allowed in the long run. Slide 34

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36. Elliott Fan: Micro 2014-2 Lecture 2 Monopolistic Competition Implications: 1.Since we expect monopolistic competitors to face quite elastic demand curves, the deviation of output from the competitive level might not be too great. 2.In the LR, profit is pressed to zero, but still not at the competitive level. Slide 36

37. Elliott Fan: Micro 2014-2 Lecture 2 Product Differentiation There are many ways to differentiate products so as to form a market close to monopolistic competition. – Brand names – Hiring an attractive girl to sell betel nuts or soy foodbetel nutssoy food – Location Slide 37

38. Elliott Fan: Micro 2014-2 Lecture 2 Economics of Location Difference exaggerated or minimized Vendor location Final location Political parties – median voter theorem Slide 38

39. Elliott Fan: Micro 2014-2 Lecture 2 Hotelling model: consumers populate uniformly on a line and two firms have to choose a position. Consumers go to the store that is closest. Slide 39

40. Fig. 25.7 40

41. Elliott Fan: Micro 2014-2 Lecture 2 Prisoner’s Dilemma – using game theory to analyze oligopoly Game with 2 players – Commit crime – Decide how to play game – Choose best strategy Invisible hand does not hold true – Repeated Prisoner’s Dilemma – Tit-for-Tat Slide 41

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43. Elliott Fan: Micro 2014-2 Lecture 2 Breakdown of Cartels Price initially set above MC – Cheating promoted Competitive output level Analogous to Prisoner’s Dilemma – Ex. NCAA Enforcers – Government – Monopoly retailer Slide 43

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45. Elliott Fan: Micro 2014-2 Lecture 2 Regulations and market power Regulations increase market power for those who meet the standards. Some benefit and some others suffer from regulations. In the case of quality regulations, for example, people with lower income suffer more. (why?) Slide 45

46. Elliott Fan: Micro 2014-2 Lecture 2 Examples of Regulation Quantity Quality Information Prices Business practices Slide 46

47. Elliott Fan: Micro 2014-2 Lecture 2 Regulating quality Typical examples are regulations on drugs. (The U. S. Food and Drug Administration, FDA, for example) They can be good and bad: – Good: poor quality drugs are harmful – Bad: access to drugs is delayed Peltzman (1987) analyzes the effect of 1938 drug regulations and concludes that mandatory prescriptions were unlikely to save lives or lead to other health improvements! Peltzman (1973) finds that the Kefauver Amendments in 1968 (requiring drug producers to prove their drugs safe) have cost more lives than saved. Slide 47

48. Elliott Fan: Micro 2014-2 Lecture 2 Regulating information Typical examples are regulations on advertisements They can be good and bad: – Good: advertisements increase costs unnecessarily – Bad: advertisements increase competition then lower prices Benham (1972) investigates this question in the market for eyeglasses and found that the price of eyeglasses was higher by 25-100% in states where advertising was prohibited. Slide 48

49. Elliott Fan: Micro 2014-2 Lecture 2 A handsome application of theory of monopoly Article by Lin Chuan, former Treasurer in Taiwan, analyzing Taipower and monopoly. Article Main argument: Rate-of-return regulation applied to a monopoly firm leads to over-investment. We have mentioned before that profit regulation (or zero profit regulation) applied to a monopoly firm leads to over production: Slide 49

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51. Elliott Fan: Micro 2014-2 Lecture 2 A handsome application of theory of monopoly Averch and Johnson's (1962) work suggested that the profit-maximizing firm under rate-of-return regulation fails to minimize the cost of producing any observed level of output, that these productive inefficiencies might be large, and that the firm might even build up its rate base by selling competitive outputs at a price below marginal cost. Slide 51

52. Elliott Fan: Micro 2014-2 Lecture 2 Averch and Johnson's argument Slide 52

53. Elliott Fan: Micro 2014-2 Lecture 2 A handsome application of theory of monopoly Figure 1 denotes the firm's production where capital x1 is plotted on the horizontal axis and labor x2 on the vertical axis. The market or "social" cost of capital and labor generates the isocost curve A and the unregulated firm would move along expansion path 1 where market cost is minimized for any given output. With regulation, however, the cost of capital to the firm- the "private" cost is lower than the market cost. For each additional unit of capital input, the firm is permitted to earn a profit. The firm moves along expansion path 2. Slide 53