Micro Chapter 11 Price-Searcher Markets with High Entry Barriers

6 Learning Goals 1)Name the reasons why entry barriers can be high 2)Characterize and explain the output decisions of a monopoly firm 3)Identify the characteristics of an oligopoly market 4)Explain the output decisions of an oligopoly firm 5)List the problems caused by high entry barriers 6)Consider government policies that can counteract the problems caused by high entry barriers

Why are Entry Barriers Sometimes High?

Q11.1 A monopoly is most likely to emerge in a market when 1.the producers in the market have U-shaped average total cost curves. 2.the price elasticity of demand for the product is high. 3.the cost of entry and exit into the market is low. 4.economies of scale are large relative to market demand.

Q11.2 The U.S. Postal Service has a monopoly on the delivery of first-class mail due to 1.economies of scale. 2.a lack of initiative on the part of competing firms. 3.legal barriers limiting entry. 4.control over an essential resource.

An entry barrier is something that prevents you from opening a business in a particular industry Preventions: (1) Sometimes you just need to start as a really big firm (example: nuclear power plant) (2) Another firm may have a license or patent that precludes you (example: USPS) (3) Somebody else owns the vital resource

Entry barriers create market power If no new firms can enter the market to steal customers and profits, the existing firms behave differently

Characteristics of Monopoly

Similar to monopolistic competition, the firm now decides price and output The firm is the market (i.e. market demand curve = firm demand curve) Continue to produce as long as MR > MC

Price Quantity/time d P MR q MC ATC C B A and price P (along the demand curve) will be charged. Price and Output Under Monopoly The monopolist will reduce price and expand output as long as MR > MC. MR > MC MR < MC The monopolist will raise price and reduce output whenever MR < MC. Output level q will result … At output q the average total cost is C. As P > C (price > ATC) the firm is making economic profits equal to the area PABC. Economic profits

Q11.3 Because monopolists are protected by high barriers to entry, 1. they may be able to earn long-run economic profits. 2. they will minimize the per-unit cost of producing their output. 3. they will price their product at marginal cost. 4. they seek economic profit; however they are not able to earn it in the long run.

If there is no substitute, why not set price at $1 million? The firm will set price according to market demand (i.e. willingness to pay) In the SR the firm can earn positive economic profit

Will LR profits be pushed to zero? No, because of entry barriers No new firm can enter and take profit away

Whenever the cost of a first-class stamp is raised, the U.S. Postal Service (USPS) undertakes a new advertising campaign. I doubt that advertising will help much, at least not in the part of its business involving letters and bills. The problem is that the long-run cost of transmitting paper documents is rising, while the long-run cost of transmitting electrons (fax, s, electronic funds transfers) is falling. The cost of a one-minute fax has fallen below 10 cents at the same time that stamp prices have risen. Until the 1980s, we mailed checks every month for the phone, electricity, gas, and mortgage. We now have these all directly debited; it’s easier, and the companies save money this way, too. The only hope for the USPS in the long run is in its lines of business where goods must be sent: parcels and express mail. Whether it is efficient enough to compete in these areas with FedEx, UPS, DHL, and others is another question. Q: The USPS has a monopoly on sending letters. Why doesn’t that monopoly guarantee it economic profits forever?

Is the monopolist guaranteed SR and LR profit? SR and LR profit can be positive, negative, or zero

Illustration of Monopoly and a change in market structure: This market moved from nearly perfect competition to monopoly overnight Watch video: Forrest Gump-monopoly

The Characteristics of an Oligopoly

The key characteristic is interdependence among firms which leads to strategic behavior

Watch video: Primetime-game theory The full episode is about 18 minutes long. Downloading or streaming the entire video may be difficult so I offer the video in two parts to make the file size smaller. Watch either version.

Game theory is often used to analyze oligopolies John Nash won the Nobel prize in economics for his pioneering work that was later used in this area Watch video: A Beautiful Mind-Nash equilibrium

Recall the other 3 industries: A perfectly competitive firm is not concerned about any other firm A monopolist doesn’t have another firm to consider A monopolistically competitive firm is only somewhat concerned about what other firms are doing

An oligopoly firm is greatly concerned about what the other firms in the industry are doing Each firm will base part of its own decisions on what they think other firms are doing or will do

Our clothes dryer died yesterday, so we went out shopping for a new one. I said we should go to Sears, but my wife thought that Sears carries only its own brand (Kenmore) of appliances. I thought that that was no longer true, and I was correct: A few years ago, Sears began carrying all major brands and trying to compete with the discount appliance stores. Why did Sears switch strategies after so many years of advertising Sears and Kenmore together? The company increasingly saw its prices being undercut by discounters as customers insisted on shopping based on price instead of on brand loyalty. The only way Sears could maintain its sales against the competition was to offer a full range of choices. Q: If you had a small appliance store offering exclusively Maytag appliances and saw places like Sears expanding to offer many different brands, what would you try to do to stay in business?

Watch video: Princess Bride-game theory

Watch video of strategic behavior (also known as prisoner’s dilemma): Golden Balls gameshow-prisoner’s dilemma

Price and Output under Oligopoly

The federal government is seeking public comments on proposals that would allow airlines to impose surcharges on fares at peak business hours at the nation’s busiest airports. Why don’t the airlines just raise these fares themselves, since they are free to do so? The problem is that they often do try to raise fares, but without success. In the last two weeks, two airlines have successively tried to increase discount fares by $20 per ticket, only to back down when they found that the other oligopolists did not follow their price increases. If the oligopolists can get the government to state that raising fares is justified as a way of reducing congestion at busy times and places, it is more likely that airlines generally will go along with price increases. A government statement would provide the “cover” industry members need to justify raising their prices at the same time; it would prevent competition between them. Q: Assume all airlines initially charged $20 more. Describe what you think would happen to prices over time.

Each analysis really becomes a case-study because: Sometimes oligopolists will act like perfectly competitive firms Sometimes they’ll act like monopolists Many times they switch between the two (act one way for awhile then another)

Ceteris paribus, what would make a firm better off? A higher price for its product How could this be achieved? If output were kept low, price would generally rise Would one firm voluntarily or even have an incentive to keep output low? Probably not because the other firms would increase production, lower price, and steal customers

What if the firms jointly agreed to keep production low? This would generally be good for all firms But the incentive to cheat would be so great that the agreement probably wouldn’t last long Watch video: 20/20-diamond cartel

Q11.4 When members of an oligopolistic industry agree to collude, raising their product price substantially above average cost, the passage of time (months and years) 1. is usually needed for the members to solidify their cooperation. 2. usually results in finer control of prices and markets by the group and larger profit margins. 3. is likely to erode the agreement, as ways to cheat are developed by some participants and new entry is encouraged by the high price. 4. seldom has any impact on the agreement, as long as the participants maintain high profit levels as a result of the agreement.

Q11.5 The two conflicting tendencies that a firm has in an oligopolistic industry are 1. the incentive to cheat to maximize joint profits and the incentive to raise prices. 2. the incentive to cheat and avoid collusion and the incentive to raise price to maximize the firm's share of profits. 3. the incentive to increase output in order to minimize per-unit costs and the incentive to reduce price in order to maximize joint profit. 4. the incentive to cooperate to maximize joint profits and the incentive to cheat on the agreement in order to increase the firm's share of the profit.

Defects of Markets with High Entry Barriers

Generally, the outcomes of monopoly and oligopoly are not as desirable as with perfect competition Output is lower Price is higher Some gains from trade are not realized Variety is lower

Policy Alternatives When Entry Barriers are High

Four options to “fix” the industry: 1)Antitrust Policy (Sherman Act, Clayton Act, FTC, etc) 2)Reduce artificial barriers 3)Regulate price and output 4)Government production

Problem with government production: Watch video: Stossel Macro Clip 15- competition and efficiency of government

Question Answers: 11.1 = = = = = 4