Competition and Market Structure Frederick University 2013

Industry Industry (market) – a collection of firms, each of which is supplying products that have some degree of substitutability, to the same potential buyers Common buyers for sellers Common sellers for buyers Relatively homogeneous product

SCP Paradigm Basic Conditions Market Structure Conduct Performance

BASIC CONDITIONS SUPPLY raw material technology product durability value/weight business attitudes unionization DEMAND price elasticity rate of growth substitutes marketing type purchase method cyclical and seasonal character

Market Structure Market Structure – those characteristics of the market that significantly affect the behavior and interaction of buyers and sellers

MARKET STRUCTURE number and size of sellers and buyers type of the product conditions of entry and exit transparency of information

Perfect Competition - structure Many and small sellers, so that no one can affect the market Homogeneous product Free entry to and exit from the industry Transparent and free information

Pure Monopoly- market structure Only one producer in the industry The product does not have close substitutes Blocked entry

Monopolistic competition - structure Many and small sellers Differentiated product Free entry and exit Transparent and free information

Oligopoly – market structure A) Tight oligopoly – a few big firms in the industry with comparable market shares/ B) Dominant firm oligopoly – one of the big firms in the industry is recognized as the price leader Homogeneous / Heterogeneous oligopoly Significant barriers to entry to and exit from the industry Significant barriers to information

Entry into an industry or to a segment of an industry can occur because there is de novo entry. takeover from outside the industry the development of technologically similar firms who develop their product range. the transference of brand names across sectors an increase in import penetration. Again, the scale of the firm involved is important here. Entry

Barriers to Entry Structural barriers High capital cost Economies of scale Product differentiation and brand loyalty High switching cost Ownership/control of key factors or outlets Strategic barriers Limit pricing Excess capacity Vertical integration Sleeping patents Predatory pricing Tying sales Institutional barriers Patents Regulations

Alternative Market Structures The four market structures perfect competition monopoly monopolistic competition oligopoly

Features of the four market structures

Market Conduct Market Conduct – a firms policies toward its market and toward the moves made by its rivals in that market

CONDUCT pricing behavior product strategy research and innovation advertising legal tactics

Perfect competition - conduct Industrys market P Q DS PePe QeQe Firms market P Q d PqTRMR MR

Perfect competition – short run conduct p Q dd = MR MC P = MRMC = MR q P>AC AC Economic profit = (P-AC) q

Perfect Competition – long run conduct Industrys equilibrium P Q D S Pe Qe P If P>AC, new firms start entering the industry and the equilibrium price falls. The industry is in a long run equilibrium when P = AC In the long run the firms make normal profit If Р < АС, the firms will start leaving the industry and the equilibrium price will increase.

fig (a) Industry P P1P1 Q (millions) S D1D1 (b) Firm d 1 = MR 1 MC P2P2 d 2 = MR 2 D2D2 P3P3 d 3 = MR 3 D3D3 Q (thousands) Perfect Competition - Deriving the short-run supply curve a b c = S The firms short run supply curve is determined by its MC curve above AVC

Q (SR)AC (SR)MC LRAC AR = MR DLDL LRAC = (SR)AC = (SR)MC = MR = AR Long-run equilibrium of the firm under perfect competition

Pure Monopoly - conduct P Q D P Q TRMR MR P>MR MC=MR MC Qm P AC Economic Profit

L P Q QmQm AR D MC AC MR Pure Monopoly and Perfect competition PmPm Qp.c. Pp.c. K N Consumer surplus = (P –MWP) Under perfect competition = KLN Under pure monopoly = NRT RT G GTL – the portion of the consumer surplus, which is a deadweight loss for the society JGL – the portion of the producer surplus, which is a deadweight loss for the society Producer surplus = (P-MC) Under pure monopoly the producer surplus rises by KGTR at the expense of the consumer surplus J TLJ – total deadweight loss for the society

P Q QsQs AR D MC AC MR Monopolistic competition – conduct in the short run PsPs AC s P>MR MC = MR

Monopolistic competition – conduct in the long run AR L D L MR L P Q QLQL PLPL LRAC LRMC If P>AC new firms will enter the industry and the firms market segment will shrink - its individual demand curve shifts leftwards The long run equilibrium is achieved at P = AC, however, АС is not minimized – there is excess capacity

fig Q2Q2 P2P2 D L under perfect competition Long run equilibrium under perfect competition and under monopolistic competition P Q P1P1 LRAC D L under monopolistic competition Q1Q1

Tight oligopoly - conduct P Q NFD FD

fig P Q P1P1 Q1Q1 FD NFD The kinked demand curve under the tight oligopoly

P Q P1P1 Q1Q1 MR f a b D AR The kinked demand curve MR nf

P Q P1P1 Q1Q1 MC 2 MC 1 MR а b D AR Rigid prices under the tight oligopoly

Price leadership of the dominant firm P Q D industry D leader S others

P Q S other firms D industry D leader PLPL MR leader MC leader QLQL QFQF QTQT f t l Price leadership of the dominant firm

Market Performance Market Performance – how well does an industry do what society might reasonably expect it to do

PERFORMANCE profitability allocative efficiency static production efficiency dynamic efficiency - progress full employment equity

Perfect Competition - Performance P = MR MC = MR P = MC P = AC AC = MC AC minimum

Perfect Competition - Performance Static Efficiency Efficiency in allocation MC = P Efficiency in motivation AC = MC Efficiency in distribution AC = P The Perfect Competition achieves static efficiency Dynamic Efficiency There is NO potential and motivation for innovations and technological progress The Perfect Competition does not achieve dynamic efficiency

Pure Monopoly - performance Static efficiency Efficiency in allocation MC < P Efficiency in motivation excess capacity Efficiency in distribution AC < P The pure monopoly does not achieve static efficiency Dynamic efficiency There is a potential and motivation for innovations and technological progress The pure monopoly is motivated to achieve dynamic efficiency at the presence of potential competition

Monopolistic competition - performance Static Efficiency Efficiency in allocation MC < P Efficiency in motivation excess capacity Efficiency in distribution AC = P

Contestable Markets Key characteristics: Firms behaviour influenced by the threat of new entrants to the industry – if even the industry is concentrated, the incumbent firms behave as if they are perfect competitors Firms performance depends on the potential competition

Contestable markets Ultra easy entry Ultra easy exit Zero sunk cost Hit and run strategy Contestable market

Oligopoly – non-collusive behavior Game theory – the study of multi-person decision problems (the reactions of a few interdependent decision makers) Game - any situation that involves well- defined rules and outcomes, where outcomes are dependent on players strategic decisions Strategy – a complete plan, specifying the game under any possible circumstances

The Prisoners dilemma Two suspects, V and G, are arrested by the police. The police have insufficient evidence for a conviction, and, having separated both prisoners, visit each of them to offer the same deal: if one testifies for the prosecution against the other and the other remains silent, the betrayer gets 3 months and the silent accomplice receives the full 10-year sentence. If both stay silent, both prisoners are sentenced to only 1 year in jail for a minor charge. If each betrays the other, each receives a three-year sentence. Each prisoner must make the choice of whether to betray the other or to remain silent. However, neither prisoner knows for sure what choice the other prisoner will make. So this dilemma poses the question: How should the prisoners act?

fig The Prisoners dilemma Does not confessConfesses Does not confess Confesses Vs alternatives Gs alterantives Everyone gets 1 year Everyone gets 3 years G - 3 months V- 10 years G - 10 years V - 3 months

The Prisoners dilemma The Prisoners dilemma is the duopolys dilemma. Prisoners cannot coordinate their confessions. Even though they both would get less if they do not confess, they betray the other player, because of the greater payoff. No matter what the other player does, one player will always gain a greater payoff by playing defect. Since in any situation playing defect is more beneficial than cooperating, all rational players will play defect.

fig Payoffs for firms A и B under different pricing policies As Price Bs Price 10mil. for each 8 for each 12 for В 5 for А 5 for В 12 for А

Collusive behavior How could the firms overcome the prisoners dilemma? How could the firms overcome the prisoners dilemma? Collusive behavior will set higher prices for the buyers!