Chapter 8 Monopoly and Imperfect Competition

Chapter 8 Monopoly and Imperfect Competition

Monopoly A monopoly firm is the only seller of a good or service with no close substitutes Market in which the monopoly firm operates is called a monopoly market Key concept is notion of substitutability Definition of monopoly firm or market may seem precise But in real world, definition is not always so clear-cut Because we all have different tastes and characteristics, we can have different opinions about what is, and what is not, a “close” substitute As a result, we can have different ideas about how broadly or how narrowly we should define a market when trying to decide if it is a monopoly Lieberman & Hall; Introduction to Economics, 2005

Why Monopolies Exist Existence of a monopoly means that something is causing other firms to stay out of the market Rather than enter and compete with firm already there What barrier prevents additional firms from entering the market? Several possible answers Economies of scale Legal barriers Network externalities Lieberman & Hall; Introduction to Economics, 2005

Economies of Scale If economies of scale persist to the point where a single firm is producing for entire market, the market is a natural monopoly Market in which, due to economies of scale, one firm can operate at lower average cost than can two or more firms Unless government intervenes, only one seller would survive—market would naturally become a monopoly Small local monopolies are often natural monopolies Because they continue to enjoy economies of scale up to point at which they are serving entire market Lieberman & Hall; Introduction to Economics, 2005

Figure 1: A Natural Monopoly
Pieces of Clothing per Week Dollars A 15 B 12 LRATC C 5 DMarket 300 350 Lieberman & Hall; Introduction to Economics, 2005

Legal Barriers Sometimes public interest is best served by having a single seller in a market Many monopolies arise because of legal barriers including Protection of intellectual property Government franchise Lieberman & Hall; Introduction to Economics, 2005

Protection of Intellectual Property
The words you are reading right now are an example of intellectual property, which includes literary, artistic and musical works, and scientific inventions In dealing with intellectual property government strikes a compromise Allows creators of intellectual property to enjoy a monopoly and earn economic profit, but only for a limited period of time Once time is up, other sellers are allowed to enter the market, and it is hoped that competition among them will bring down prices Most important kinds of legal protection for intellectual property are Patents Temporary grant of monopoly rights over a new product or scientific discovery Copyrights Grant of exclusive rights to sell a literary, musical, or artistic work Copyrights and patents are often sold to another person or firm, but this does not change monopoly status of the market, since there is still just one seller Lieberman & Hall; Introduction to Economics, 2005

Government Franchise Large firms we usually think of as monopolies have their monopoly status guaranteed through government franchise Grant of exclusive rights over a product Barrier to entry is Any other firm that enters the market will be prosecuted Governments usually grant franchises when they think market is a natural monopoly Lieberman & Hall; Introduction to Economics, 2005

Network Externalities
Exist when an increase in network’s membership increases its value to current and potential members When network externalities are present, joining a large network is more beneficial than joining a small network Even if product in larger network is somewhat inferior to product in smaller one In addition to advantages of joining a larger network Advantage in not leaving it once you’ve joined Avoiding switching costs Lieberman & Hall; Introduction to Economics, 2005

Network Externalities
All of this clearly applies to the market for computer operating systems When you buy a computer already loaded with Microsoft Windows, you benefit By having a large number of people with whom you can easily share documents Huge number of computers everywhere you can easily operate You gain access to many more software programs, like Microsoft Word, Excel, or Outlook, since many more programs are designed for Windows than for the few alternatives You can save time by just calling knowledgeable friends or coworkers Rather than attempting to contact technical support Lieberman & Hall; Introduction to Economics, 2005

Monopoly Goals And Constraints
Goal of a monopoly—like that of any firm—is to earn highest profit possible However, a monopolist faces constraints Constraint on monopoly’s cost For any level of output it might produce, total cost is determined by Technology of production Price it must pay for its inputs Demand constraint Monopolist’s demand curve tells us maximum price monopolist can charge to sell any given quantity of output And for any level of output it might produce, maximum price it can charge is determined by market demand curve for its product Lieberman & Hall; Introduction to Economics, 2005

Monopoly Price or Output Decision
Noncompetitive firms—such as monopolies—do not make two separate decisions about price and quantity, but rather one decision Once firm determines its output level, it has also determined its price When any firm—including a monopoly—faces a downward sloping demand curve, marginal revenue is less than price of output Therefore, marginal revenue curve will lie below demand curve Monopoly will produce at an output level where marginal revenue is positive Lieberman & Hall; Introduction to Economics, 2005

Figure 2: Demand and Marginal Revenue
Number of Subscribers Monthly Price per Subscriber $60 50 A B 48 C 38 30 20 F G 18 Demand 5,000 15,000 20,000 30,000 6,000 MR 21,000 Lieberman & Hall; Introduction to Economics, 2005

The Profit-Maximizing Output Level
To maximize profit, the firm should produce level of output where MC = MR and MC curve crosses MR curve from below For a monopoly, price and output are not independent decisions But different ways of expressing the same decision Lieberman & Hall; Introduction to Economics, 2005

Figure 3: Monopoly Price and Output Determination
Number of Subscribers Monthly Price per Subscriber 40 $60 MC E D 10,000 30,000 MR Lieberman & Hall; Introduction to Economics, 2005

Profit And Loss A monopoly earns a profit whenever P > ATC
Its total profit at best output level equals area of a rectangle Height equal to distance between P and ATC Width equal to level of output A monopoly suffers a loss whenever P < ATC Its total loss at best output level equals area of a rectangle Height equal to distance between ATC and P Lieberman & Hall; Introduction to Economics, 2005

Figure 4: Monopoly Profit and Loss
Dollars (a) Number of Subscribers (b) ATC MC ATC MC AVC $50 E E $40 40 32 Total Loss Total Profit D D 10,000 10,000 MR MR Lieberman & Hall; Introduction to Economics, 2005

The Shut-Down Decision
What if a monopoly suffers a loss in short-run? Any firm should shut down if P < AVC at output level where MR = MC If monopoly suddenly finds that P < AVC, government will usually not allow it to shut down, Instead use tax revenue to make up for firm’s losses Lieberman & Hall; Introduction to Economics, 2005

Monopoly in the Long-Run
In the short run, a monopoly may earn an economic profit or suffer an economic loss But what about the long run? Important insights of previous chapter—perfectly competitive firms cannot earn a profit in long-run equilibrium However, monopolies may earn economic profit in long-run A privately owned monopoly suffering an economic loss in long-run will exit the industry Should not find privately owned monopolies suffering economic losses in long-run Lieberman & Hall; Introduction to Economics, 2005

Comparing Monopoly to Perfect Competition
In perfect competition, economic profit is relentlessly reduced to zero by entry of other firms In monopoly, economic profit can continue indefinitely But monopoly differs from perfect competition in another way Can expect a monopoly market to have a higher price and lower output than an otherwise similar perfectly competitive market By raising price and restricting output, new monopoly earns economic profit Consumers lose in two ways Pay more for output they buy Due to higher prices they buy less output Lieberman & Hall; Introduction to Economics, 2005

Figure 5(a/b): Comparing Monopoly and Perfect Competition
Quantity of Output Price per Unit (a) Competitive Market (b) Competitive Firm Dollars per Unit 2. and each firm produces 1,000 units, where P = MC. S MC ATC E $10 3. When monopoly takes over, the old market supply curve . . . $10 d D 100,000 1,000 1. In this competitive market of 100 firms, equilibrium price is $10 Lieberman & Hall; Introduction to Economics, 2005

Figure 5(c): Comparing Monopoly and Perfect Competition
(c) Monopoly Price per Unit S = MC 4. becomes the monopoly's MC curve. F $15 E 5. The monopoly produces where MR = MC, 10 6. with a higher price and lower market output than under perfect competition. MR D Quantity of Output 100,000 60,000 Lieberman & Hall; Introduction to Economics, 2005

Comparing Monopoly to Perfect Competition
Changeover from perfect competition to monopoly benefits owners of monopoly and harms consumers of the product Important proviso concerning this result In comparing monopoly and perfect competition, price is higher and output is lower under monopoly if all else is equal General conclusion Monopolization of a competitive industry leads to two opposing effects For any given technology of production, monopolization leads to higher prices and lower output Changes in technology of production made possible under monopoly may lead to lower prices and higher output Ultimate effect on price and quantity depends on relative strengths of two effects Lieberman & Hall; Introduction to Economics, 2005

The Decline of Monopoly?
Past century was not kind to monopolies Today, monopolies face a different threat Relentless advance of technology The world of monopolies is changing rapidly But monopolies in many forms will be with us for some time Lieberman & Hall; Introduction to Economics, 2005

Monopolistic Competition
Imperfect competition refers to market structures between perfect competition and monopoly In imperfectly competitive markets, there is more than one seller, but still too few to create a perfectly competitive market In addition, imperfectly competitive markets often violate other conditions of perfect competition, such as the requirement of a standardized product or free entry and exit Monopolistic competition is a market sturcture with three fundamental characteristics 1. Many buyers and sellers 2. Sellers offer a differentiated product 3. Sellers can easily enter into or exit from the market Because it produces a differentiated product, a monopolistic competitor faces a downward-sloping demand curve When it raises its price a modest amount, quantity demanded will decline (but not all the way to zero) Lieberman & Hall; Introduction to Economics, 2005

Monopolistic Competition in the Short-Run
Individual monopolistic competitor behaves very much like a monopoly Key difference is this While a monopoly is the only seller in its market, a monopolistic competitor is one of many sellers When a monopolistic competitor raises its price, its customers have one additional option Can buy similar good from some other firm Lieberman & Hall; Introduction to Economics, 2005

Figure 6: A Monopolistically Competitive Firm in the Short Run
Dollars Homes Serviced per Month 1. Kafka services 250 homes per month, where MC and MR intersect . . . A MC $70 ATC 2. and charges $70 per home. d1 30 3. ATC at 250 units is less than price, so profit per unit is positive. MR1 4. Kafka's monthly profit–$10,000–is the area of the shaded rectangle. 250 Lieberman & Hall; Introduction to Economics, 2005

Monopolistic Competition in the Long-Run
Under monopolistic competition—in which there are no barriers to entry and exit—the firm will not enjoy its profit for long Entry will continue to occur, and demand curve will continue to shift leftward Under monopolistic competition, firms can earn positive or negative economic profit in short-run But in long-run, free entry and exit will ensure that each firm earns zero economic profit just as under perfect competition In real world, monopolistic competitors often earn economic profit or loss in the short-run But—given enough time—profits attract new entrants, and losses result in an industry shakeout Until firms are earning zero economic profit Lieberman & Hall; Introduction to Economics, 2005

Figure 7: A Monopolistically Competitive Firm in the Long Run
In the long run, profit attracts entry, which shifts the firm's demand curve leftward. Dollars Homes Serviced per Month MC ATC E Entry continues until P = ATC at the best output level, and economic profit is zero. $40 d1 The typical firm produces where its new MR crosses MC. MR1 MR2 d2 100 250 Lieberman & Hall; Introduction to Economics, 2005

Nonprice Competition If monopolistic competitor wants to increase its output it can cut its price Move along its demand curve Any action a firm takes to increase demand for its output—other than cutting its price—is called nonprice competition Examples include better service, product guarantees, free home delivery, more attractive packaging Nonprice competition is another reason why monopolistic competitors earn zero economic profit in long-run All this nonprice competition is costly Must pay for advertising, for product guarantees, for better staff training Costs must be included in each firm’s ATC curve, shifting it upward None of this changes conclusion that monopolistic competitors will earn zero economic profit in long-run Lieberman & Hall; Introduction to Economics, 2005

Oligopoly When just a few large firms dominate a market
So that actions of each one have an important impact on the others Would be foolish for any one firm to ignore its competitors’ reactions In such a market, each firm recognizes its strategic interdependence with others An oligopoly is a market dominated by a small number of strategically interdependent firms Lieberman & Hall; Introduction to Economics, 2005

Economies of Scale: Natural Oligopolies
When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market A large firm—supplying a large share of the market—will have lower cost per unit than a small firm Since small firms can’t compete, only a few large firms survive Market becomes an oligopoly Tends to happen on its own unless there is government intervention Such a market is often called a natural oligopoly—analogous to natural monopoly Lieberman & Hall; Introduction to Economics, 2005

Reputation as a Barrier
A new entrant may suffer just from being new Established oligopolists are likely to have favorable reputations In some cases, where potential profits are great, investors may decide it is worth the risk and accept initial losses in order to enter industry In other industries, the initial losses may be too great and probability of success too low for investors to risk their money starting a new firm Lieberman & Hall; Introduction to Economics, 2005

Strategic Barriers Oligopoly firms often pursue strategies designed to keep out potential competitors Maintain excess production capacity as a signal to a potential entrant that they could easily saturate market and leave new entrant with little or no revenue Make special deals with distributors to receive best shelf space in retail stores Make long-term arrangements with customers to ensure that their products are not displaced quickly by those of a new entrant Spend large amounts on advertising to make it difficult for a new entrant to differentiate its product Lieberman & Hall; Introduction to Economics, 2005

Legal Barriers Patents and copyrights—which can be responsible for monopoly—can also create oligopolies Like monopolies, oligopolies are not shy about lobbying government to preserve their market domination Government barriers can operate against domestic entrants, too Lieberman & Hall; Introduction to Economics, 2005

Oligopoly Behavior Oligopoly presents the greatest challenge to economists Essence of oligopoly is strategic interdependence Wherein each firm anticipates actions of its rivals when making decisions In order to understand and predict behavior in oligopoly markets Economists have had to modify the tools used to analyze other market structures and to develop entirely new tools as well One approach—game theory—has yielded rich insights into oligopoly behavior Lieberman & Hall; Introduction to Economics, 2005

The Game Theory Approach
An approach to modeling strategic interaction of oligopolists in terms of moves and countermoves In all games—except those of pure chance, such as roulette—a player’s strategy must take account of the strategies followed by other players Game theory analyzes oligopoly decisions as if they were games by Looking at the rules players must follow Payoffs they are trying to achieve Strategies they can use to achieve them Lieberman & Hall; Introduction to Economics, 2005

Simple Oligopoly Games
Duopoly Oligopoly market with only two sellers Assume that Gus and Filip must make their decisions independently Without knowing in advance what the other will do No matter what Filip does, Gus’s best move is to charge a low price—his dominant strategy A similar analysis from Filip’s point of view, would tell us that his dominant strategy is the same: a low price Equilibrium price in market is the low price Lieberman & Hall; Introduction to Economics, 2005

Fig. 4: A Duopoly Game Gus’s Actions Confess Gus’s profit = $25,000
Don’t Confess Filip’s Actions Gus’s profit = $25,000 Filip’s Profit = $25,000 = –$10,000 = $75,000 = $50,000 $–10,000 $75,000 $50,000 Gus’s Actions Lieberman & Hall; Introduction to Economics, 2005

Oligopoly Games in the Real World
Will typically be more than two strategies from which to choose Will usually be more than two players In some games, one or more players may not have a dominant strategy When one player has a dominant strategy, we can still predict the game’s outcome Whether the other has a dominant strategy or not Lieberman & Hall; Introduction to Economics, 2005

Cooperative Behavior in Oligopoly
In real world, oligopolists will usually get more than one chance to choose their prices The equilibrium in a game with repeated plays may be very different from equilibrium in a game played only once Often, firms will evolve some form of cooperation in the long run Lieberman & Hall; Introduction to Economics, 2005

Explicit Collusion Simplest form of cooperation is explicit collusion
Managers meet face-to-face to decide how to set prices Most extreme form of explicit collusion is creation of a cartel Group of firms that tries to maximize total profits of the group as a whole If explicit collusion to raise prices is such a good thing for oligopolists, why don’t they all do it? Usually illegal Penalties, if the oligopolists are caught, can be severe But oligopolists can collude in other, implicit ways Lieberman & Hall; Introduction to Economics, 2005

Tacit Collusion Any time firms cooperate without an explicit agreement, they are engaging in tacit collusion Tit for tat A game-theoretic strategy of doing to another player this period what he has done to you in previous period However, gentle reminder of tit-for-tat is not always effective in maintaining tacit collusion Oligopolist will sometimes go further Attempting to punish a firm that threatens to destroy tacit cooperation Lieberman & Hall; Introduction to Economics, 2005

Tacit Collusion Another form of tacit collusion is price leadership
One firm—the price leader—sets its price and other sellers copy that price With price leadership, there is no formal agreement Rather the decisions come about because firms realize—without formal discussion—that system benefits all of them Decisions include Choice of leader Criteria it uses to set its price Willingness of other firms to follow Lieberman & Hall; Introduction to Economics, 2005

The Limits to Collusion
Oligopoly power—even with collusion—has its limits Even colluding firms are constrained by market demand curve Collusion—even when it is tacit—may be illegal Collusion is limited by powerful incentives to cheat on any agreement Lieberman & Hall; Introduction to Economics, 2005

The Future of Oligopoly
Some people think U.S. and other Western economies are moving toward oligopoly as dominant market structure In 1932, two economists—Adolf Berle and Gardiner Means—noted trend toward big business Predicted the 200 largest U.S. firms would control nation’s entire economy by 1970 Unless something were done to stop it Prediction has not come true Today, there are hundreds and thousands of ongoing businesses in United States Lieberman & Hall; Introduction to Economics, 2005

Antitrust Legislation and Enforcement
Antitrust enforcement has focused on three types of actions Preventing collusive agreements among firms Such as price-fixing agreements Breaking up or limiting activities of large firms—oligopolists and monopolists—whose market dominance harms consumers Preventing mergers that would lead to harmful market domination Managers of other firms considering anticompetitive moves have to think long and hard about consequences of acts that might violate antitrust laws While thrust of these policies is to preserve competition Type of competition preserved—and zeal with which policies are applied—can shift Lieberman & Hall; Introduction to Economics, 2005

The Globalization of Markets
By enlarging markets from national ones to global ones, international trade can increase the number of firms in a market Decreasing market dominance by a few, and increasing competition Although oligopolists often try to prevent it, they face increasingly stiff competition from foreign producers Entry of U.S. producers has helped to increase competition in foreign markets for movies, television shows, clothing, household cleaning products, and prepared foods While consumers in each nation may have access to more firms, these may be larger and more powerful firms Creating greater likelihood of strategic interaction and danger of collusion Lieberman & Hall; Introduction to Economics, 2005

Technological Change Technological change works to increase competition by creating new substitute goods Can reduce barriers to entry in much the same way that globalization does By increasing size of market Technology—the internet—has enabled residents in many smaller towns to choose among a dozen or more online sellers of the same merchandize Trend can also be seen as encouraging oligopoly Result could be strategic interaction, or collusion, among large national players Finally, some technologies actually increase MES of typical firm Thereby encouraging formation of oligopolies Lieberman & Hall; Introduction to Economics, 2005

Figure 9(a): Advertising in Monopolistic Competition
1.Before advertising, long-run economic profit is zero. 2. In the short run, the first firms to advertise earn economic profit. Dollars Bottles of Perfume per Month 3. But in the long run, imitation and entry bring economic profit back to zero. B $120 C 100 ATCads ATCno ads A 60 4. Advertising can lead to a higher price in the long run, as in this panel . . . dads dall advertise dno ads 1,000 6,000 2,000 Lieberman & Hall; Introduction to Economics, 2005

Figure 9(a): Advertising in Monopolistic Competition
5. or to a lower price in the long run, as in this panel. Dollars Bottles of Perfume per Month dall advertise B $120 A 60 C ATCads 50 ATCno ads dads dno ads 1,000 6,000 2,000 Lieberman & Hall; Introduction to Economics, 2005

Using the Theory: Advertising in Monopolistic Competition and Oligopoly
Perfect competitors never advertise and monopolies advertise relatively little But advertising is almost always found under monopolistic competition and very often in oligopoly Why? All monopolistic competitors, and many oligopolists, produce differentiated products Since other firms will take advantage of opportunity to advertise, any firm that doesn’t advertise will be lost in shuffle Lieberman & Hall; Introduction to Economics, 2005

Using the Theory: Advertising and Market Equilibrium Under Monopolistic Competition
A monopolistic competitor advertises for two reasons To shift its demand curve rightward (greater quantity demanded at each price) To make demand for its output less elastic So it can raise price and suffer a smaller decrease in quantity demanded Can summarize impact of advertising as illustrated in panel (a) Since each firm must pay costs of advertising, and more competitors have entered the market, Narcissus and its competitors are each earning normal economic profit—just as they were originally Advertising has raised the price from $60 to $100 in long- run But this is not the only possible result Lieberman & Hall; Introduction to Economics, 2005

Using the Theory: Advertising and Market Equilibrium Under Monopolistic Competition
Because you and I and everyone else is buying more perfume Each producer can operate closer to capacity output, with lower costs per unit In long-run, entry will force each firm to pass cost savings on to us Analysis suggests the following conclusion Under monopolistic competition, advertising may increase size of market, so that more units are sold But in long-run, each firm earns zero economic profit, just as it would if no firm were advertising Price to consumer, however, may either rise or fall Lieberman & Hall; Introduction to Economics, 2005

Advertising and Collusion in Oligopoly
Oligopolists have a strong incentive to engage in tacit collusion But in some cases can use a simple game theory model to show that collusion is almost certainly taking place Take airline industry as an example In theory, any airline should be able to claim superior safety Yet no airline has ever run an advertisement with information about its security policies or attacked those of a competitor Airlines are playing against each other repeatedly and reach the kind of cooperative equilibrium we discussed earlier Lieberman & Hall; Introduction to Economics, 2005

Figure 10: An Advertising Game
Run Safety Ads Don't Run Ads United's Actions American's Actions American earns low profit American earns high profit United earns very low profit United earns low profit American earns very low profit American earns medium profit United earns medium profit United earns high profit Lieberman & Hall; Introduction to Economics, 2005

The Four Market Structures: A Postscript
Different market structures Perfect competition Monopoly Monopolistic competition Oligopoly Market structure models help us organize and understand apparent chaos of real-world markets Lieberman & Hall; Introduction to Economics, 2005

Chapter 8 Monopoly and Imperfect Competition

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