Market Equilibrium and Market Demand: Imperfect Competition Chapter 9

Market Structure Characteristics We characterize an industry by No. of firms and size dist. Product differentiation Unique products? Barriers to entry The picture to the right concerned with two markets: Pages No. 2 yellow corn: many producers and sellers (Perfect Competition) Farm equipment: few manufacturers and sellers (Oligopoly)

Perfect Competition We have been assuming the firm and market reflect conditions of perfect competition Not a bad assumption for many agric. subsectors A large number of small firms 2 million farms A homogeneous product No. 2 yellow corn Freely mobile resources No barriers to entry caused by patents, etc. or barriers to exit (???) Perfect knowledge of market conditions Quality outlook information from government, university and private sources Dramatic reduction in costs of obtaining information and increase the speed of information acquisition 3

Imperfect Competition Many markets in which farmers buy inputs and sell their products however do not reflect perfect competition conditions Chapter 9 focuses on specific types of imperfect competitors in the farm input market These firms are capable of setting prices farmers must pay for specific inputs 4

Imperfect Competition in Selling 5

Measures of Concentration Page Quantitative measures of the degree of competition in a market Concentration Ratio (CR) % of the total market revenue accounted for by 2 (CR2), 4 (CR4), 8 (CR8), 20 (CR20), etc. largest firms in the industry Low CR values a high degree of competition High CR values an absence of competition

Page Quantitative measures of competition Herfindahl-Hirschman Index (HHI) The square of % market share of each firm summed over the largest 50 firms or all firms if there are < 50 firms in the industry Perfect competition, HHI is small Only 1 firm, HHI is 10,000 = (100 2 ) U.S. Justice Department oHHI < 1,000 competitive markets oHHI > 1,800 could be considered concentrated industry worthy of Justice Dept. examination of any purchases of other firms in the industry Measures of Concentration

Page HHICR4CR8CR20CR50 HHICR4CR8CR20CR50 All Food Manufac Soft Drinks Flour Manufac Cigarettes Soybean Processing Carpet/Rug Mills Breakfast Cereal Pulp Mills Fluid Milk Petrochemical Cheese Manufac Aluminum Poultry Processing Farm Equipment Snack Food Auto/Light Truck Whether an industry is concentrated depends on how narrowly it is defined In terms of the product it produces Extent of the geographic area it serves Measures of Concentration

Consolidation in the U.S. Dairy Industry Page 165 9

Page Measures of Concentration

Page Measures of Concentration Cooperative CR Values of Total U.S. Milk Marketed

Page Measures of Concentration AreaDec 97Dec 98Dec 99AreaDec 97Dec 98Dec 99 Atlanta Atlanta Boston Boston Charlot te Charlot te Cincinn ati Cincinn ati Dallas Dallas Denver Denver Miami Miami U.S. CR4: Market Avg Percentage of Fluid Milk Marketed by 4 Largest Processor Dec Dec by City (Source: GAO, 2001)

Topics for Discussion Monopolistic Competition Definition Production and Pricing Decisions Oligopolies Definition/Examples Production and Pricing Decisions Monopolies Definition/Examples Production and Pricing Decisions Comparison of Market Structures Pages

14 Imperfect Competition in Selling At the firm level, unlike perfect competitors who face a perfectly elastic (horizontal) demand curve Imperfect competitors selling a differentiated product have a downward sloping demand curve A B Firms demand curve under imperfect competition Firms demand curve under imperfect competition A B Firms demand curve under P.C. Firms demand curve under P.C. Q Q $ $

15 Page 149 PriceQuantityTotal Rev.Avg. RevenueMarginal Revenue Table 9-1 Imperfect Competition Marginal Revenue (MR) : Change in revenue from the sale of the last unit of output (ΔTR÷ΔQ) Average Revenue (AR): Total Revenue/Total output (TR÷Q) Marginal Revenue (MR) : Change in revenue from the sale of the last unit of output (ΔTR÷ΔQ) Average Revenue (AR): Total Revenue/Total output (TR÷Q) 20 Note: Price = Average Revenue Firm faces a downward sloping demand curve MR AR 2

Page Imperfect Competition in Selling Marginal Revenue (MR): Change in revenue from the sale of the last unit of output

Page 150 Marginal revenue in this instance is also downward sloping MR=0 at the point where TR is at a maximum Marginal revenue in this instance is also downward sloping MR=0 at the point where TR is at a maximum 17 Imperfect Competition in Selling Maximum Total Revenue

Types of Imperfect Competitors in Input Markets Monopolistic Competition Oligopoly Monopoly 18 Lets start here…

Monopolistic Competitors Many sellers Each firm has relatively small market share Power to set prices somewhat like a monopoly Face competition like perfect competition Collusion is not possible given number of firms in the industry No barriers to entry or exit Page

Monopolistic Competitors Page Product Differentiation: Each firm makes a product that is slightly different from the products of competing firms Close substitutes but not perfect substitutes An attempt to price will normally results in a in volume sold Competition on Quality, Price, and Marketing Quality in design, reliability, service provided to buyer and ease of access to product The firm faces a downward sloping demand curve Firm must market intensively: promotions, distribution, packaging, etc.

Monopolistic Competitors Page Product differentiation does not necessarily mean there are any physical differences among products They might all be the same, but how they are sold may make all the difference

Monopolistic Competitors Page The monopolistic competitor tries to set his/her product apart from the competition Main method is via advertising When this is done successfully, the demand curve becomes more vertical or inelastic Buyers are willing to pay more because they believe it is much better than their other choices Basis for product differentiation Physical differences Convenience AmbienceReputation Appeals to vanitySnob appeal

Monopolistic Competitors Page Typical Monopolistic Competitor Tries to set firm apart from competition New Product Development and Innovation Advertising o Create consumer perception of product differentiation – real or imagined o Attempt to keep demand as inelastic as possible Selling costs can be extremely high

Monopolistic Competitors Short run profits can exist but long run profits are reduced to 0 with industry entrants Fast food industry is a good example All services basically the same Extensive use of marketing to differentiate products/services across firms Striving to produce more products and services Page

Monopolistic Competitors How much of the product does this firm produce? Determine output level where MC = MR (Why does this make sense?) What price should the firm charge for this product? Locate on the downward sloping demand curve where above quantity intersects Associated price on this demand curve Page

Page The firm produces Q SR where MR=MC at E Prices its products at P SR by reading off the demand curve at quantity Q SR Represents consumers willingness to pay for Q SR The firm produces Q SR where MR=MC at E Prices its products at P SR by reading off the demand curve at quantity Q SR Represents consumers willingness to pay for Q SR Short run profits exist if: P SR > ATC SR at Q SR Monopolistic Competitors $/unit Q MC ATC Q SR P SR ATC SR MR Firm Demand Profits E

Page Monopolistic Competitors $/unit Q MC ATC Q SR P SR ATC SR MR Firm Demand Loss E Short run loss At Q SR, P SR < ATC SR Short run loss At Q SR, P SR < ATC SR

Page Monopolistic Competitors $/unit Q MC ATC Q LR ATC LR = P LR MR Firm Demand E In the Long Run (LR) Profits are bid away as more firms enter the market Losses will no longer exist as firms leave the market At Q LR the remaining firms are just breaking even In the Long Run (LR) Profits are bid away as more firms enter the market Losses will no longer exist as firms leave the market At Q LR the remaining firms are just breaking even

Monopolistic Competitors Page How much is the industry dominated or not dominated by few suppliers Depends on the geographical scope – national, regional, global An industry can be almost perfectly competitive on a national scope, but almost a monopoly locally e.g. local farm supply cooperative Depends on the existence of barriers to entry and exit Industries may appear concentrated but few barriers exist to prevent entry which implies less ability to dominate market

Oligopolies A few number of sellers Each can impact market price and quantities Interdependent in their decision making A firm will consider how other firms will react to pricing, promotional and other actions Key component in marketing strategies and pricing behavior Pages

Rival oligopolists will match price cuts but not price increases in the short run as they want to capture larger market share If there are differences in prices they are the result of successful product differentiation Non-price competition between oligopolists used to uniquely identify products Tend to have stable prices Changes in production and other costs not easily passed on and may have to be absorbed Pages Oligopolies

Price leadership strategy A particular firm dominates the market Controls the largest share of the market Other industry firms more efficient in operation, marketing, etc. The dominant firm first sets its price to maximize profit Remaining firms set their prices based on the dominant firms pricing The price set by the oligopolist seller is higher then under perfect competition Quantity produced is lower then perfect comp. Pages

Oligopolies The dominant firm may be efficient enough to set a lower price Eventually drive the other firms out of the market Pages

Oligopolies Examples of Oligopolies Auto manufacturers 2007 CR4 value of 73.7 Aircraft manufacturing 2007 CR4 value of 81.3 Farm machinery and equipment John Deere, J.I.Case and New Holland 80% of 2-wheel drive tractors close to 90% of combines sold in the U.S. Cattle slaughtering CR4 value increased from 39 to 67 over the period 2007 CR4 value of 59.4 Pages

Oligopolies Pages D D d d Demand curve DD All oligopolists move prices together and share market Demand curve DD All oligopolists move prices together and share market Original demand curve dd A single firm changes its price Curve DD is more inelastic Below point A, other firms match price cut This leads to a kinked demand curve dAD Leads to a discontinuous marginal revenue curve, dBCE Original demand curve dd A single firm changes its price Curve DD is more inelastic Below point A, other firms match price cut This leads to a kinked demand curve dAD Leads to a discontinuous marginal revenue curve, dBCE A B C E Remember oligopolists account for the reaction of other firms so there is no single demand curve

Oligopolies Pages D D d A B C E Meeting demand along the lower segment of the kinked demand curve the firm is maintaining its market share MC

Oligopolies Pages D D d A B C E MC MC* Shifting MC curve to MC* reflecting technological advances will not affect P E and Q E It does impact profits as MC drops Shifting MC curve to MC* reflecting technological advances will not affect P E and Q E It does impact profits as MC drops PEPE QEQE

Monopolies One seller in the market Firm and market demand curve are the same Entry of other firms restricted by patents, etc. (i.e., barrier to entry) Firm has absolute power over setting market price Produces a unique product It can have economic profits in the long run because it can set price without competition Page

Monopolies Page MC ATC AVC Demand= AR MR TVC 0 N M PEPE C B A QEQE Total revenue = area 0P E CQ E Monopolist produces quantity where MC=MR (pt A), Q E Uses the demand curve (pt C) when setting price P E Total revenue = area 0P E CQ E Monopolist produces quantity where MC=MR (pt A), Q E Uses the demand curve (pt C) when setting price P E $/unit Quantity

Monopolies Page MC ATC AVC Demand= AR MR TVC 0 N M PEPE C B A QEQE $/unit Quantity Total variable costs for the monopolist is equal to area 0NAQ E, (green box) =AVC x Q E = 0N x Q E Total variable costs for the monopolist is equal to area 0NAQ E, (green box) =AVC x Q E = 0N x Q E

Monopolies Page MC ATC AVC Demand= AR MR TFC 0 N M PEPE C B A QEQE $/unit Quantity Total fixed costs equals NMBA (orange box) =(ATC-AVC) x Q E Total fixed costs equals NMBA (orange box) =(ATC-AVC) x Q E

Monopolies Page MC ATC AVC Demand= AR MR TFC TVC 0 N M PEPE C B A QEQE $/unit Quantity Total cost is area 0MBQ E (green box + orange box) = area ONAQ E + area NMBA Total cost is area 0MBQ E (green box + orange box) = area ONAQ E + area NMBA

Monopolies Page MC ATC AVC Demand= AR MR TFC TVC 0 N M PEPE Economic Profit C B A QEQE $/unit Quantity Monopoly economic profit = area MP E CB = Total Revenue (yellow box) – Total Costs (green box + orange box) Monopoly economic profit = area MP E CB = Total Revenue (yellow box) – Total Costs (green box + orange box)

Monopolies Page MC ATC AVC Demand= AR MR TFC TVC 0 N M PEPE Economic Profit C B A QEQE $/unit Quantity Total fixed costs equals NMBA (orange box) =(ATC-AVC) x Q E Total fixed costs equals NMBA (orange box) =(ATC-AVC) x Q E

Comparison of Structure Results Lets compare the results we have obtained from the alternative market structures 45

Perfect Competition Page Demand 0 Q PC $/unit Quantity MR Supply Consumer surplus = sum of areas 1, 4, 5, 8 and 9 (Pink triangle) Producer surplus = sum of areas 2, 3, 6 and 7 (green triangle) Total economic surplus = sum of blue and green triangles = sum of areas 1 – 9 P PC

Monopoly Case Page Demand 0 QMQM $/unit Quantity MR Supply Consumer surplus = sum of areas 8 and 9 (Pink triangle) 1 Compared to P.C., consumers would be economically worse-off by areas 1, 4 and 5 Paying a higher price, P M Purchasing a smaller quantity, Q M Compared to P.C., consumers would be economically worse-off by areas 1, 4 and 5 Paying a higher price, P M Purchasing a smaller quantity, Q M P PC PMPM Q PC

Monopoly Case Page Demand 0 QMQM $/unit Quantity MR Supply 1 P PC PMPM Q PC PS = to sum of areas 3, 4, 5, 6 and 7 (green area) Compared to P.C. producers lose area 2 but gain areas Producers economically better-off than perfect competition Compared to P.C. producers lose area 2 but gain areas Producers economically better-off than perfect competition

Monopoly Case Page Demand 0 QMQM $/unit Quantity MR 2 Supply 1 P PC PMPM Q PC Purple triangle is total economic surplus under perfect competition Orange triangle is total economic surplus under monopoly Society as a whole economically worse-off by areas (Green triangle) Known as the dead weight loss Reflects the fact that less resources in this market are used to provide products to consumers Purple triangle is total economic surplus under perfect competition Orange triangle is total economic surplus under monopoly Society as a whole economically worse-off by areas (Green triangle) Known as the dead weight loss Reflects the fact that less resources in this market are used to provide products to consumers

Summary of Impacts of Alternative Market Structures from a Selling Perspective Page

Imperfect Competition From the Buying Perspective 51

Types of Imperfect Competitors on the Buying Side Monopsonistic competition Oligopsony Monopsony Lets start here… 52

Monopsonies Single buyer in the input market Focus is on the marginal input cost of purchasing additional amounts of an input If the objective of the buying firm is to maximize profit, what is the decision rule as to how much of an input should be purchased? Page

Monopsonies General Profit maximizing input use rule for any firm type: To maximize profit the firm should continue to purchase additional units of an input so long as the extra revenue generated by the additional input use is greater than the additional cost associated with that additional input use So long as Revenue > Cost when purchasing additional units Page

Monopsonies Under perfect competition, the firm views its input supply curve as a horizontal line Firm can purchase as much as desired as the going price Firms purchases do not impact inputs price Page Labor Wage Rate $12.50 Supply curve faced by a P.C. firm L1L1 L1L1

Monopsonies Monopsonist must consider the marginal input cost (MIC) when purchasing inputs MIC: Extra cost associated with purchasing an additional unit of input Monopsonist must pay higher prices per unit if he/she wants to purchase greater amounts of the input MIC curve is above the input supply curve Page

Monopsonies Monopsonist is the only input buyer Faces an upward sloping input supply curve Input purchasing decisions impact input prices Page Labor Wage Rate $12.50 Supply curve faced by a monopsonist L1L1 $15.75 L2L2

Marginal Input Cost Page Units of Variable Input Price/Unit ($) Total Input Cost Marginal Input Cost

Marginal Input Cost Page $/Unit Quantity/unit of time Marginal Input Cost Input Supply Curve Data obtained from previous table Data obtained from previous table 59

Monopsonies Profit maximizing monopsonist Use variable input to the point where Marginal Input Cost (MIC) =Marginal Revenue Product (MRP) MRP: Addition to total revenue attributed to use of one more unit of variable input MRP = Marginal Revenue (MR) x MPP = (Revenue/Output) x (Output/Input) = Revenue/Input = MVP when MR = P MIC: Extra cost associated with purchasing an additional unit of input Page

Monopsonies So long as MRP > MIC profits will increase with increased input use If MRP < MIC, profits will by reducing the amount of input used Why will this occur? Page

Monopsonies Page MIC Input Supply Monopsony Input Quantity $ QMQM CMCM P.C. in output market MRP = MVP under P.C. MVP=P x MPP Profit Max. MVP = MIC P.C. in output market MRP = MVP under P.C. MVP=P x MPP Profit Max. MVP = MIC MRP With monopsony, MIC > C M C M = input cost/unit under monopsony C P.C. = input cost/unit under P.C. input market C M = input cost/unit under monopsony C P.C. = input cost/unit under P.C. input market MIC = MVP Input Supply P.C. C P.C. Q P.C.

Monopsonies Page MIC Input Supply M Input Quantity $ QMQM CMCM MRP Input Supply P.C. C P.C. Q P.C. Resource use Higher Price paid under P.C., C P.C. Utilization higher under P.C., Q P.C. Price difference referred to as monopsonistic exploitation (i.e., C P.C. – C M )

Imperfect Competition on Both Sides Page 160 Product Selling Perspective Input Purchasing Perspective Perfect Competition Monopolistic Competition Monopsonistic Competition OligopolyOligopsony MonopolyMonopsony Can have any combination of the above for a particular firm Lets look at profit maximization under specific cases 64

Introduction to Agricultural Economics, 5 th ed Penson, Capps, Rosson, and Woodward © 2010 Pearson Higher Education, Upper Saddle River, NJ All Rights Reserved. Page

Page MIC Input Supply M Input Quantity $ Q MM C MM MRP Case #1: Monopsonist in input purchasing and Monopolist seller of product Equilibrium: MRP = MIC at Point A Pricing off input supply curve gives Q MM and C MM Case #1: Monopsonist in input purchasing and Monopolist seller of product Equilibrium: MRP = MIC at Point A Pricing off input supply curve gives Q MM and C MM MVP A Use MR not output price (P Y ) due to being a monopolist (i.e., single seller of output) MRP = MR*MPP I dont display the MVP curve as not relevant for monopolist Use MR not output price (P Y ) due to being a monopolist (i.e., single seller of output) MRP = MR*MPP I dont display the MVP curve as not relevant for monopolist

Page Input Supply PC Input Quantity $ Q PCM C PCM MRP MVP C Case #2: Perfect Competition in input purchasing and Monopoly seller Equilibrium is where MRP=Supply at C No Marginal InputCost curve Q PCM and P PCM Case #2: Perfect Competition in input purchasing and Monopoly seller Equilibrium is where MRP=Supply at C No Marginal InputCost curve Q PCM and P PCM Input price determined by input market Take input price as given Input price determined by input market Take input price as given

Page MIC Input Supply M Input Quantity $ Q MPC C MPC D Case #3: Monopsony in input purchasing and Perfectly Competitive seller Equilibrium: MVP=MIC at Point E Pricing off supply curve Q MPC and P MPC at point D Case #3: Monopsony in input purchasing and Perfectly Competitive seller Equilibrium: MVP=MIC at Point E Pricing off supply curve Q MPC and P MPC at point D E We use MVP instead of MRP curve given P.C. seller MVP = P Y x MPP

Page Input Supply PC Input Quantity $ Q PC C PC F Case #4: Perfect Competition in both input purchasing and product sales Equilibrium: MVP=Supply at Point F Q PC and P PC Case #4: Perfect Competition in both input purchasing and product sales Equilibrium: MVP=Supply at Point F Q PC and P PC Input price determined by input market Input price determined by input market MVP = P Y x MPP We use MVP instead of MRP curve given P.C. seller

Monopsonistic Competitors Many firms buying resources Ability to differentiate services to producers Differentiated services includes distribution convenience and location of facilities, willingness to provide credit or technical assistance P and Q determined same as monopsonist Page

Oligopsonies A few number of buyers of a resource Profit earned will depend on elasticity of supply for resource (less elastic than monopsonistic competition) Each oligopsonist knows fellow oligopsonists will respond to changes in price or quantity it might initiate P and Q determined same as monopsonist Page

Governmental Regulation Various approaches have been used to counteract adverse effects of imperfect competition in the marketplace Legislative acts passed by Congress, including the Sherman Antitrust and Clayton Acts Price ceilings Lump-sum Tax Minimum price or floors Page

Legislative Acts Sherman Antitrust Act of 1890 Prohibited monopoly and other restrictive business practices Packers and Stockyards Act of 1921 Reinforced anit-trust laws regarding livestock marketing Capper-Volstead Act of 1922 Exempted cooperatives from anti-trust laws Robinson-Patman Act Prohibited price discrimination practices Agricultural Marketing Agreement Act Established agricultural marketing orders Page

Impacts of Price Ceilings Regulatory agencies such as the Federal Trade Commission can impact monopoly effects by instituting a maximum (ceiling) price FTC charged with investigating business organizations and practices and carrying out anti-trust provisions How can we model the impact of price ceilings? Page

Page MC ATC Demand MR 0 A PMPM B C QMQM $/unit Quantity Implications of a Price Ceiling D Without regulatory involvement the monopolist will Equate MR and MC (pt C) Produce Q M and charge price P M Total Revenue = 0P M BQ M Total Cost = 0ADQ M Earn a profit of AP M BD Without regulatory involvement the monopolist will Equate MR and MC (pt C) Produce Q M and charge price P M Total Revenue = 0P M BQ M Total Cost = 0ADQ M Earn a profit of AP M BD Impacts of Price Ceilings

Page MC ATC Demand 0 PMPM B C QMQM $/unit Quantity Implications of a Price Ceiling Impacts of Price Ceilings With govt imposed price ceiling, P MAX The demand curve is given by P MAX EH MR is P MAX EFG Monoopolist produces more (Q 1 > Q M ) at a lower price (P MAX < P M ) With govt imposed price ceiling, P MAX The demand curve is given by P MAX EH MR is P MAX EFG Monoopolist produces more (Q 1 > Q M ) at a lower price (P MAX < P M ) P MAX E F G H Q1Q1 I J Monopolists profit falls to area JP MAX EI (turquoise box)

Impacts of a Lump Sum Tax A regulatory agencies can impact the level of monopoly profits by assessing a lump-sum tax May be a license fee or one-time charge This is a fixed tax regardless of output level How can we model the impact of a lump sum tax? Page

Page MC ATC Demand MR 0 A PMPM B C QMQM $/unit Quantity Implications of a Lump Sum Tax D Impacts of a Lump Sum Tax The monopolist equates MC=MR (pt. C) Produces Q M Charges P M Profit of AP M BD The monopolist equates MC=MR (pt. C) Produces Q M Charges P M Profit of AP M BD ATC* Lump-sum tax firms ATC to ATC * producer surplus from AP M BD to EP M BT Does not change output level or price Lump-sum tax firms ATC to ATC * producer surplus from AP M BD to EP M BT Does not change output level or price E T Per Unit Tax Loss in PS surplus is area AETD (pink box)

Impacts of a Minimum Price In a monopsony, the govt could regulate the price of a resource by imposing a minimum price that must be paid for that resource A good example is the minimum wage laws How can we model the impact of a minimum price policy on how much of the input may be purchased? Page

Page MIC Input Supply Input Quantity $ QMQM CMCM MRP Impacts of a Minimum Price No minimum price Monopsonist determines where MRP=MIC Employ Q M input units Pays $C M /unit No minimum price Monopsonist determines where MRP=MIC Employ Q M input units Pays $C M /unit Implications of a Minimum Price Minimum price, C F, imposed Monopsonists MIC curve would be C F DEB The firm would use more input, Q M Q F Minimum price, C F, imposed Monopsonists MIC curve would be C F DEB The firm would use more input, Q M Q F CFCF D E F QFQF

Summary Unlike perfect competition, imperfect competitors have ability to influence price Monopolistic competitors try to differentiate their product Monopolists are the only seller in their product market. Monopsonists are the only buyer Oligopolies are a few number of sellers while oligopsonies are a few number of buyers. What are the economic welfare implications of imperfect competition? 81

Chapter 10 focuses on natural resource use in agriculture and the impacts on the environment 82