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Advanced Monopoly Topics. Contestable Markets and Strategies to Deter Entry A monopoly firm may not set profit maximizing prices because they want to.

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Presentation on theme: "Advanced Monopoly Topics. Contestable Markets and Strategies to Deter Entry A monopoly firm may not set profit maximizing prices because they want to."— Presentation transcript:

1 Advanced Monopoly Topics

2 Contestable Markets and Strategies to Deter Entry A monopoly firm may not set profit maximizing prices because they want to keep the price low enough to keep other firms out. A market in which the possibility of market entry tempers the behaviors of monopolists is called a contestable market. –A pricing strategy to prevent entry is called limit pricing. Firms may also use other strategies to deter entry which are less beneficial than lowering prices and increasing production.

3 Strategies of Entry Deterrence A firm may deter entry by competitors by threatening them with : –Engaging in predatory pricing. Price below marginal cost to drive another firm out of the market. –Building excess capacity (promise predatory pricing)

4 Oligopoly Many industries are dominated by a small number of firms: Airlines, airplane manufacturing, supermarkets, drugstores. In theory, even a small number of firms may compete, driving down prices to the level of costs. –Airplane manufacturing: Boeing vs. Airbus Oligopolists may also collude! –OPEC –Sotheby’s and Christie’s

5 Concentration Ratios are often used to measure market competition

6 Conditions of Cartel Small number of firms Barriers to Entry Ineffective or Non-existent government regulation. Way to Stop Cheating –Enforcer –Capacity Constraints (California Electricity Market)

7 Duopolists Two companies can agree on a price at which they could make profits. If the other firm keeps its word, you can win whole market by undercutting their price. If the other firm doesn’t keep its word, you must undercut the agreed upon price or lose everything. Either way, best strategy is to cheat on agreement.

8 Example: Two Firms

9 Payoff Matrix Two firms Each one could choose to collude and charge a price of 475. Or each could decide to cheat, steal the market for themselves and charge a price of 450 The matrix describes the payoff of each firm given the strategies of another. Red Firm 1 Blue Firm 2 ColludeCheat Collude6250, , 11,250 Cheat11,250,

10 Game Theory & Beautiful Mind Game Theory is a branch of math that describes strategic interactions. Nash describes a game that is in equilibrium as one in which no player has an incentive to change their strategy given the strategy of the other player. Nash equilibrium in the above game is for both to cheat even though they both players would be better off if they could collude.

11 California, 2000 In 1998, utilities in California’s deregulated wholesale power market were paying between $30 and $40 per MWH. By summer and fall of 2000, prices skyrocketed to $140. Five firms producing wholesale electricity (Enron, Dynegy,…). When there is excess capacity, five firm market behaved relatively competitively. When capacity constraints hit, firms could exercise significant pricing power and raise prices above marginal cost.

12 Sotheby’s and Christies Prior to 1995, Sotheby's and Christie's, the world's largest auction houses, were in fierce competition for consignments from sellers.,…. In March 1995, this competition abruptly ended. Christie's … would charge sellers a fixed, non-negotiable commission … and a month later Sotheby's announced the same policies. Detailed documents kept by …, Christie's former chief executive, show that the abrupt change was due to a price-fixing conspiracy. Anatomy of the Rise and Fall of a Price- Fixing Conspiracy: Auctions at Sotheby's and Christie's Orley Ashenfelter and Kathryn Graddy ** Why were these firms able to successfully form a cartel? Firms may compare future profits from staying in cartel relative to current profits from cheating. In lean markets, the benefits from cheating may be less than the future benefits from staying in a cartel.

13 Boeing vs. Airbus. Why might it be difficult for two airlines to collude. There is a large stock of existing aircraft available for sale in used market. Durable goods producers have to compete with their own past. Some economists claim that Alcoa did not have a monopoly because the broad supply of recycled Aluminum.

14 Price Discrimination What if you don’t have to charge the same price to everyone? If you have perfect knowledge of the valuation applied to your product by each customer, you might tailor your price for each one. Since lowering your price for each customer doesn’t affect the price obtained from higher value customers, you gain by selling at a price above marginal cost.

15 P Q MC = 3 Total profit earned by firm P1P1 P2P2 P3P3 P4P4 P5P5 P6P6

16 P Q P Perfect Price Discrimination will generate same output as perfect competion, but monopolist will take all surplus as profit.

17 Learning Outcomes Students should be able to: Describe the conditions that characterize markets with monopoly, oligopoly, and monopolistic competition. Differentiate perfect competition, monopolistic competition, and regulated and unregulated monopoly in terms of output and price relative marginal cost and or total costs. Discuss types of barriers of entry, entry deterrence strategies and the consequences of uncontested markets. Define price discrimination and discuss the costs and benefits to the firm and society. Evaluate the difficulties of maintaining collusion

18 Surplus The demand curve represents how much consumers are willing to pay for one more unit of a good, if they have already bought a certain number of goods. There are diminishing returns to any given product. As people consume more of that product, the benefit they get from consuming another one declines, and they are only willing to pay a lower price. Difference between the price people are willing to pay for a good (i.e. the position of the price schedule) and the actual price is the consumer surplus (net benefit to the consumer) generated by that purchase.

19 P Q P = 3 Surplus generated by buying first good = 6

20 P Q P = 3 Surplus generated by buying second good = 5

21 P Q P = 3 Total consumer surplus is the sum of surplus of each good

22 P Q P When goods adjust continuously, total consumer surplus is a triangle created by price line and demand curve

23 Producer Surplus Producers achieve profits whenever they sell an extra goods at a price above the cost of producing the extra good. Sum of profits for each good is the total producer surplus, the area in the triangle below the price line and above the supply curve.

24 Competitive Market P* Q* D S Producer Surplus

25 Competitive Equilibrium is Efficient Economic efficiency means that there are no gains to be had at the level of society from additional trades. If the price is higher or lower, the sum of the areas of the consumer & producer surplus triangles will be less than at the equilibrium price. Economic efficiency does not guarantee that the split of the surplus will coincide with any notion of fairness.

26 Efficient Equilibrium Market Producer Surplus Consumer Surplus P* S D

27 Monopoly Price P* Q* Ceiling S D

28 Total Societal Surplus is lower under monopoly Q* Ceiling Producer Surplus Consumer Surplus Deadweight Loss S D

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