Market Structures

The Degree of Competition Classifying markets number of firms freedom of entry to industry nature of product nature of demand curve The four market structures perfect competition monopoly monopolistic competition oligopoly

Features of the four market structures 3

Perfect Competition Assumptions Short-run equilibrium of the firm firms are price takers freedom of entry identical products perfect knowledge Short-run equilibrium of the firm price, output and profit

Short-run equilibrium of industry and firm under perfect competition Firm is a price taker. Price is given by the market. AC MC P O £ (b) Firm Q (thousands) S D AR D = AR = MR Pe AC O Qe Q (millions) (a) Industry 5

Loss minimising under perfect competition Loss is minimised where MC = MR. AC MC P £ S AC D1 = AR1 = MR1 AR1 Qe P1 D O O Q (millions) Q (thousands) (a) Industry (b) Firm 6

Deriving the short-run supply curve £ MC D1 = S D2 a D1 = MR1 D3 P1 b D2 = MR2 P2 c D3 = MR3 P3 O O Q (millions) Q (thousands) (a) Industry (b) Firm 7

Perfect Competition Long-run equilibrium of the firm all supernormal profits competed away LRAC = AC = MC = MR = AR

Long-run equilibrium under perfect competition Profits return to normal Supernormal profits New firms enter LRAC P £ S1 D Se P1 AR1 D1 PL ARL DL O O QL Q (millions) Q (thousands) (a) Industry (b) Firm 9

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

Perfect Competition Incompatibility of economies of scale with perfect competition Benefits of perfect competition price equals marginal cost prices kept low firms must be efficient to survive

Monopoly Defining monopoly Barriers to entry economies of scale economies of scope product differentiation and brand loyalty ownership/control of key factors ownership/control over outlets legal protection

Monopoly The monopolist’s demand curve Equilibrium price and output downward sloping MR below AR Equilibrium price and output Equilibrium output, where MC = MR Equilibrium price, found from demand curve

Profit maximising under monopoly £ MC AC AR AR AC MR O Qm Q

Monopoly The monopolist’s demand curve Equilibrium price and output downward sloping MR below AR Equilibrium price and output Equilibrium output, where MC = MR Equilibrium price, found from demand curve Profit Measuring profit

Profit maximising under monopoly £ MC Total profit AC AR AR AC MR O Qm Q

Monopoly The monopolist’s demand curve Equilibrium price and output downward sloping MR below AR Equilibrium price and output Equilibrium output, where MC = MR Equilibrium price, found from demand curve Profit Measuring profit Supernormal profit can persist in long run

Monopoly Disadvantages of monopoly high prices / low output: short run

Equilibrium of industry under perfect competition and monopoly: with the same MC curve £ AR = D MR Monopoly P1 O Q1 Q

Equilibrium of industry under perfect competition and monopoly: with the same MC curve £ MC ( = supply under perfect competition) Comparison with Perfect competition P1 P2 AR = D MR O Q1 Q2 Q

Monopoly Disadvantages of monopoly Advantages of monopoly high prices / low output: short run high prices / low output: long run lack of incentive to innovate Advantages of monopoly economies of scale profits can be used for investment high profits encourage risk taking

Monopolistic Competition Assumptions of monopolistic competition Equilibrium of the firm short run

Short-run equilibrium of the firm under monopolistic competition MC £ AR = D MR AC Ps ACs O Qs Q

Monopolistic Competition Assumptions of monopolistic competition Equilibrium of the firm short run long run

Long-run equilibrium of the firm under monopolistic competition £ New firms entering the industry reduce demand for each individual firm. LRMC LRAC Price falls to PL. ARL = DL MRL PL O QL Q

Monopolistic Competition Assumptions of monopolistic competition Equilibrium of the firm short run long run underutilisation of capacity in the long run

Long run equilibrium of the firm under perfect and monopolistic competition £ Higher price and lower output (excess capacity) under monopolistic competition LRAC P1 P2 DL under perfect competition DL under monopolistic competition O Q1 Q2 Q 27

Monopolistic Competition Assumptions of monopolistic competition Equilibrium of the firm short run long run underutilisation of capacity in the long run Non-price competition The public interest comparison with perfect competition comparison with monopoly

Oligopoly Key features of oligopoly Competition versus collusion barriers to entry interdependence of firms Competition versus collusion Collusive oligopoly: cartels equilibrium of the industry

Profit-maximising cartel £ Industry profit maximised at Q1 and P1 Industry MC P1 Members must agree to restrict total output to Q1. Industry D = AR Industry MR O Q1 Q 30

Oligopoly Key features of oligopoly Competition versus collusion barriers to entry interdependence of firms Competition versus collusion Collusive oligopoly: cartels equilibrium of the industry allocating and enforcing quotas

Oligopoly Tacit collusion price leadership: dominant firm price leadership: barometric rules of thumb

Price leader aiming to maximise profits for a given market share £ MC l t PL QL QT AR = D market Leader maximises profit at QL and thus sets price of PL. AR = D leader MR leader O Q 33

Oligopoly Factors favouring collusion few firms open with each other similar production methods and average costs similar products dominant firm significant entry barriers stable market no government measures to curb collusion

Oligopoly The breakdown of collusion factors to consider in deciding whether to break an agreement how likely are rivals to retaliate? who would win a price war? importance of considering rivals’ reactions

Oligopoly Non-collusive oligopoly: assumptions about rivals’ behaviour rivals produce fixed quantity: Cournot model firms choose best output for remainder of the market

Cournot model: Firm A’s profit-maximising position MCA Firm A’s profit-maximising output and price are QA1 and PA. Costs and revenue PA1 QA1 DA1 DM MRA1 O QB1 Quantity 37

The Cournot model of duopoly Firm A’s reaction function for each assumed output of B £ RA MCA Firm B’s output PA1 QB1 x QA1 DM DA1 MRA1 O QA1 O QB1 Quantity Firm A’s output (a) Firm A’s profit-maximising position (b) The two firms’ reaction functions 38

The Cournot model of duopoly Equilibrium at point e, where the two reaction functions cross £ RA MCA Firm B’s output PA1 e RB QBe QAe QB1 x DM DA1 MRA1 O QA1 O QA1 QB1 Quantity Firm A’s output (a) Firm A’s profit-maximising position (b) The two firms’ reaction functions 39

Oligopoly Non-collusive oligopoly: assumptions about rivals’ behaviour rivals produce fixed quantity: Cournot model firms choose best output for remainder of the market profit will be less than under a cartel but more than under perfect competition rivals set a particular price: Bertrand model the firm will undercut the rival this will probably trigger a price war until all supernormal profits are eliminated

Oligopoly Non-collusive oligopoly: assumptions about rivals’ behaviour (cont.) Nash equilibrium when everyone makes a decision based on the alternatives rivals could adopt Nash equilibrium worse for the individual firms than the collusive equilibrium The kinked demand curve model assumptions of the model stable prices

Kinked demand for a firm under oligopoly £ Assumption 1 If the firm raises its price, rivals will not. D Assumption 2 If the firm reduces its price, rivals will feel forced to lower theirs too. P1 D O Q Q1 42

Stable price under conditions of a kinked demand curve £ MC2 MR MR is discontinuous between a and b. If MC is anywhere between MC1 and MC2, profit is maximised at Q1. MC1 P1 a b D = AR O Q Q1 43

Oligopoly Oligopoly and the consumer advantages disadvantages incentive to develop new and better products greater choice for consumers than under monopoly disadvantages less scope for economies of scale than under monopoly more extensive advertising and other costly marketing difficulties in drawing general conclusions 8 44

Game Theory Non-collusive oligopoly: game theory Single-move games alternative strategies maximax and maximin simple dominant strategy games 6 45

Profits for firms A and B at different prices X’s price £2.00 £1.80 A B £5m for Y £12m for X £2.00 £10m each Y’s price C D £12m for Y £5m for X £1.80 £8m each

Game theory Non-collusive oligopoly: game theory Single-move games alternative strategies maximax and maximin simple dominant strategy games the prisoners’ dilemma 6

The prisoners’ dilemma Amanda's alternatives Not confess Confess A B Nigel gets 10 years Amanda gets 3 months Not confess Each gets 1 year Nigel's alternatives C D Nigel gets 3 months Amanda gets 10 years Each gets 3 years Confess

Game Theory Non-collusive oligopoly: game theory Single-move games alternative strategies maximax and maximin simple dominant strategy games the prisoners’ dilemma Nash equilibrium non-dominant strategy games 6

Profit possibilities for Firm X

Profit possibilities for Firm X

Game theory Repeated games more complex non-dominant strategy games multiple moves the importance of threats and promises credible threats the importance of timing decision trees 6

A decision tree Airbus decides Boeing decides Airbus decides (1) B1 Boeing –£10m Airbus –£10m (1) 500 seater Airbus decides B1 500 seater 400 seater Boeing +£30m Airbus +£50m (2) Boeing decides A 400 seater Boeing +£50m Airbus +£30m (3) 500 seater Airbus decides B2 400 seater Boeing –£10m Airbus –£10m (4)

Game Theory Repeated games more complex non-dominant strategy games multiple moves the importance of threats and promises credible threats the importance of timing decision trees first mover advantage 6 54

A decision tree Airbus decides Boeing decides Airbus decides (1) B1 Boeing –£10m Airbus –£10m (1) 500 seater Airbus decides B1 500 seater 400 seater Boeing +£30m Airbus +£50m (2) Boeing decides A 400 seater Boeing +£50m Airbus +£30m (3) 500 seater Airbus decides B2 400 seater Boeing –£10m Airbus –£10m (4)

Game Theory Limitations of game theory complex games with multiple players the role of individuals’ morals and attitudes Potential for cycles of collusion and competition 6 56