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Imperfect Competition A short Intro Peter Berck April 2006.

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1 Imperfect Competition A short Intro Peter Berck April 2006

2 Marginal Revenue When a monopolist makes one more unit of a good he receives MR And it costs her MC Let’s look at MR again….

3 Marginal Revenue P(Q+1) By adding 1 unit a monopolist gains The area is 1 wide by P high = P Q Q+1 P(Q) The monopolist looses This area is the decrease in price, which is the slope of demand times Q. So MR is the sum of the two areas MR= P + Q (slope demand)

4 MR and Competition Q Q+1 P(Q) q Let Q = nq. Competitor loses just q times slope and gains P whilst monopolist looses Q times slope (n times as much) and gains P. So when n is big, MR = Q/n slope+ P is approx P.

5 For n large MR = Q/n slope+ P So for large n MR just collapses to P And that is why in competition p=mc.

6 Strange Case of CA El.

7 Oligopoly N isn’t one and it isn’t large There are “few” sellers The ‘few’ sellers have a large incentive (a share of monopoly profits) to collude. Each individual seller also has a large incentive to cheat on the cartel –Gets more than his share. –Hopefully the others won’t find out.

8 Major types of Organization Competition Monopolistic Competition Oligopoly Monopoly (from Perloff’s Microeconomics p 425)

9 Competition p= mc Profits = 0 Free entry Many firms Price taker (mr = p) Undifferentiated product Ag commodities are example

10 Monopolistic Competition mr = mc Sets price Free entry and so zero profits Many firms Probably differentiated product Firms don’t act together! Possibly many consumer goods (cereal) and maybe services like hair stylists

11 Zero Profit Monopoly Exercise: draw the standard monopoly diagram so that the monopoly has zero profits. Verify that p > mc Story: as more firms enter the demand curve is shifted inward until there are no profits and no more firm’s enter.

12 Oligopoly mr = mc ; sets price Hard to enter Few firms P > mc Could be differentiated Automobiles in the 1950’s and 60’s. Steel at the turn of the century. OPEC, sometimes.

13 Monopoly Just one seller; no entry P > mc For a while de beers in diamonds, owners of patents and copyrights

14 OPEC OPEC is a cartel. It is an organization whose job is to increase price over the competitive level. Sometimes they can do it. Sometimes they can’t.

15 Oil Prices

16 The oil diagram explained In the aftermath of the Arab-Israel Yom Kippur War in 1973, OPEC attempted an embargo on oil sales to the US and other supporters of Israel. At the same time, Saudia Arabia cut its production by 35%. The Saudi reduction in output is what is responsible for the 1973 price increase.

17 Now to 1978 In 1978 OPEC again began production controls which were aided by the turmoil in Iran and the Iran-Iraq war. Both Iran and Iraq were major oil producers. Prices increased until 1981 when they peaked at $31.77 a barrel. During this period there was an increase in output by non OPEC nations and a slow but steady decrease in quantity demanded. Prices then slid all the way to $12.51 in 1986.

18 Three Problems Countries start to buy less oil. For instance, Sweden has shifted out of oil for heating. New oil is found and produced. Members of the cartel cheat—sell more than they pledged to sell.

19 More recent history With the first Gulf war and the end of sales by Iraq and Kuwait prices again increased and subsided to $10.87. From there prices have increased to close to $60 per barrel. The 2005 price spike is believed to be from an increase in demand from India and China.

20 Airlines Again source is Perloff, this time from a study by Brander and Zhang. Quantity setting game. Two airlines that share a city pair. Since two, called duopoly. Decide how many seats to make available Seats are thousand per quarter and profits are in millions of $

21 qAm = 64qAM = 48 qU = 644.1 5.1 3.8 qU = 483.8 5.1 4.6 Quantity Game

22 Not the Outcome the Airlines Want They could collude. Many allegations that they do exactly that.

23 Reduced commissions For instance, all the airlines together reduced the commissions to travel agents –? Collusion Lets do lunch and screw the customer –? Competition Too many travel agents (was true) –? Conscious parallelism plus E.g. one signaled that they were going to do it and let the rest prepare.

24 Current case EU alleges that airlines have fixed cargo rates over the Atlantic. –Is p > mc? –Are there few airlines –Is entry difficult? –Do they have a tape recording of the lunch… (smoking gun.)

25 Can you detect cheating How would american know united had sold a lot of extra seats? –Could they distinguish it from a change in traffic from bad economic conditions –Suppose that they both subscribed to a data service that independently tracked seats –Suppose that a large number of united seats got sold through sabre owned by AA

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