1. Topic 7: Market Structures Agenda, Friday 26 th November 2010 A: Supply and Perfect Competition B: Monopoly C: Perfect Competition v. Monopoly D: Oligopoly and Game Theory

2. A: Supply and Perfect Competition

3. Firm Supply u How does a firm decide how much to supply at a particular market price? (Firm’s supply curve) u This depends upon the firm’s – goals (e.g. π max, revenue max, zero π, … ); – technology (e.g. w, r, … ); – competitive environment/market structure.

4. Perfect Competition Assumptions u There are many buyers and sellers, –each seller is (or at least acts as) a price-taker u Homogeneous product u Freedom of entry and exit u Perfect information (consumers know all prices and producers know all input prices/costs)

5. The Firm’s Short-Run Supply Decision? u Assume each firm is a profit- maximizer u Therefore, each firm chooses its output level by solving: MR = MC But MR = P in perfect competition Therefore P = MC

6. The Firm’s Short-Run Supply Decision? P y pepe ys*ys*y’ At y = y s *, p = MC and MC slopes upwards, y = y s * is profit- maximizing. MC s (y)

7. The Firm’s Short-Run Supply Decision? P y pepe y’ So a profit- maximizing supply level can lie only on the upwards sloping part of the firm’s MC curve. MC s (y) ys*ys*

8. The Firm’s Short-Run Supply Decision? u The firm will not supply any output if Shut Down Point: P = AVC(y)

9. The Firm’s Short-Run Supply Decision? AVC s (y) AC s (y) MC s (y) The firm’s short-run supply curve Shutdown point P y

10. Short Run Market Supply Curve P Q Market Supply Curve is the sum of all the firms supply curves (  MC) S

11. Perfect Competition: Equilibrium u Short run: (Excess, Abnormal, Supernormal, Economic) Profits or Losses (≤ TVC) possible u Short run → Long run: Profits attracts entry, market supply curve shifts to right, market price falls, zero economic profits in long run equilibrium u Short run → Long run: Losses “attracts” exit, …

12. Application: Tax Incidence In Perfect Competition Q P Market Demand Market Supply P C = P P No tax: P C = P P (Consumer price = Producer price)

13. Application: Tax Incidence In Perfect Competition Q P Market Demand Market Supply P The tax creates a wedge between the price firms receive (P p ) and the price consumers pay (P c ). The difference is the tax (which goes to the tax authorities). PCPC This is the tax.

14. Application: Tax Incidence In Perfect Competition Q P Market Demand Market Supply P In the short run, the burden of the tax is shared (not necessarily on a 50/50 basis) between consumers and producers. PCPC This is the tax

15. Application: Tax Incidence In Perfect Competition In the short run, u The producers receives less for the product. u Some firms will continue to produce output at a loss (once the reduced price is covering their average variable costs). u Some firms will experience “excessive” losses and so will exit the market. u The supply curve shifts to the left and the prices consumers and producers face increases.

16. Application: Tax Incidence In Perfect Competition In the Long Run, u Consumers pay all of the tax (100%) u Producers pay none of tax (0%) u There are no firms making losses left in the market.

17. B: Monopoly

18. Monopoly: Why? u Natural monopoly (economies of scale or density) - utility companies, e.g. electricity or natural gas or cable or rail (transmission) network, household waste collection u Statutory monopoly –a patent; e.g. a new drug –sole ownership of a resource; e.g. a toll bridge u Artificial monopoly, e.g. explicit formation of a cartel, e.g. OPEC

19. Monopoly: Assumptions u Many buyers u Only one seller i.e. not a price-taker u (Homogeneous product) u Perfect information u Restricted entry (and possibly restricted exit)

20. Monopoly: Market Behaviour y = Q p(y) Higher output y causes a lower market price, p(y). D

21. Monopoly: Equilibrium y = q = Q P MR Demand

22. Monopoly: Equilibrium y P AC MC MR Demand

23. Monopoly: Equilibrium y P AC MC MR Output Decision MC = MR ymym Demand

24. Monopoly: Equilibrium y P AC MC MR Demand P m = price ymym PmPm

25. Monopoly: Equilibrium u Firm = Market u Short run equilibrium diagram = long run equilibrium diagram (apart from shape of cost curves and possibility of exit) u At q m, p m > AC therefore you have excess (economic, supernormal, abnormal) profits u Short run losses are also possible

26. Monopoly: Equilibrium y P AC MC MR Demand The shaded area is the excess profit ymym PmPm

27. Application: Tax Incidence in Monopoly y P MC MR Demand MC curve is assumed to be constant (for ease of analysis)

28. Application: Tax Incidence in Monopoly u Claim When you have a linear demand curve, a constant marginal cost curve and a tax is introduced, price to consumers increases by “only” 50% of the tax, i.e. “only” 50% of the tax is passed on to consumers. (Similarly, if tax is eliminated, only 50% of price reduction is passed on to consumers.)

29. Application: Tax Incidence in Monopoly y P MC bt MR Demand y bt Output decision is as before, i.e. MC = MR So Y bt is the output before the tax is imposed

30. Application: Tax Incidence in Monopoly y P MC bt MR Demand y bt Price is also the same as before P b t = price before tax is introduced. P bt

31. Application: Tax Incidence in Monopoly y P MC bt MR Demand y bt The tax causes the MC curve to shift upwards MC at P bt

32. Application: Tax Incidence in Monopoly y P MC bt MR Demand y bt Price post tax is at P pt and is higher than before. MC at P bt y at P pt

33. C: Monopoly v. Perfect Competition

34. Agenda u Societal Welfare/Economic Welfare: Criteria? Consumer Surplus Producer Surplus u Compare Monopoly and Perfect Competition

35. Economic Welfare u Consumer surplus measures (net) economic welfare from the buyer/consumers’ perspective. u Producer surplus measures (net) economic welfare from the seller/producers’ perspective.

36. Consumer Surplus u Consumer surplus is the amount a buyer is willing to pay for a product minus the amount the buyer actually pays. u Consumer surplus is the area below the demand curve and above the market price. A lower market price will increase consumer surplus (provided that the product is still supplied, of course). A higher market price will reduce consumer surplus.

37. Producer Surplus u Producer surplus is the amount a seller is paid for a product minus the total variable cost of production.  A higher market price will increase producer surplus (provided that the product is still demanded, of course).  A lower market price will decrease producer surplus. u Producer surplus is equivalent to economic profit in the long run.

38. Economic Welfare u Economic welfare is (generally) quantified as the sum of consumer surplus and producer surplus, i.e. equal weights are generally assumed. u Alternative relative weights are also possible.

39. Consumer Surplus and Producer Surplus: Market Equilibrium Price Equilibrium price 0Quantity Equilibrium quantity A Supply C B Demand D Producer surplus Consumer surplus E

40. Monopoly v. Perfect Competition Q P MC Demand Price is P pc P pc Q pc

41. Monopoly v. Perfect Competition Q P MC MR Demand QmQm Recall that for monopoly, MR  Demand P pc Q pc Output is set where MC = MR

42. Monopoly v. Perfect Competition Q P MC MR Demand QmQm PmPm The monopoly output is less than the perfectly competitive output. P pc Q pc (The monopoly price is higher than the perfectly competitive price.)

43. Monopoly v. Perfect Competition Q P MC MR Demand QmQm PmPm The green area represents the deadweight loss (triangle) of Monopoly P pc Q pc

44. Economic Efficiency: Monopoly v. Perfect Competition CommentPC v. M Allocative Efficiency? P = MC? PC  M X Productive Efficiency?Minimum point on AC Curve? PC  M X? Excess profit?+ Rent seeking? PC  M X X-inefficiency?“Excessive” Costs? PC  M ? Technical progress/innovation? Monopoly excess profits can be reinvested PC ? M ? Natural monopoly?Perfect competition impossible PC X M 

45. D: Oligopoly & Game Theory

46. Oligopoly: Assumptions u Many buyers u Very small number of major sellers (  actions and reactions are very important) u Homogeneous product (usually, but not necessarily) u Complete information (usually, but not necessarily) u Restricted entry (usually, but not necessarily)

47. Oligopoly & Game Theory: Models 1. Cournot Competition (1838) (Bertrand Competition (1883)) 2. Nash Equilibrium (1950s): Game Theory 3. Oligopoly v. Perfect Competition v. Monopoly 4. Some examples of Games

48. 1. Cournot Competition u Firms compete in quantities (q 1, q 2 ) u Real world examples? u q 1 = F(q 2 ) and q 2 = G(q 1 ) or more precisely q 1 = F(q 2 e ) and q 2 = G(q 1 e ) u Aim: Find q 1 and q 2 and hence P, i.e. find the equilibrium. u Example: P = a – bQ and Ci = cq i

49. 1. Cournot Competition: Example q2q2 q1q1 COURNOT EQUILIBRIUM

50. 2. Cournot Competition & Bertrand Competition: Nash Equilibrium Cournot Nash (q 1, q 2 ): Firms compete in quantities, i.e. Firm 1 chooses the best q 1 given q 2 and Firm 2 chooses the best q 2 given q 1 [Bertrand Nash (p 1, p 2 ): Firms compete in prices, i.e.Firm 1 chooses the best p 1 given p 2 and Firm 2 chooses the best p 2 given p 1 ] Nash Equilibrium (s 1 *, s 2 * ): Player 1 chooses the best s 1 given s 2 * and Player 2 chooses the best s 2 given s 1 *

51. 3. Perfect Competition v Monopoly v Oligopoly (Cournot) Q m < Q co < Q PC P m > P co > P pc

52. 4. Examples of Games: Advertising Game (≈ Prisoners’ Dilemma) Firm j AdvertiseDon’t Advertise Firm i Advertise(i=2,j=2)(i=4,j=1) Don’t Advertise (i=1,j=4)(i=3,j=3)

53. 4. Advertising Game (≈ Prisoners’ Dilemma) u Nash equilibrium = Advertise, Advertise = [2,2] u [2,2] < [3,3] i.e. Nash equilibrium can be inefficient! (We are ignoring consumer interests.) u Government bans advertising (e.g. for cigarettes or spirits or beer or ban on below cost selling?)

54. 4. Examples of Games: Eating Out Game Person j ChineseItalian Person i Chinese(i=4,j=2)(i=1,j=1) Italian(i=1,j=1)(i=2,j=4)

55. 4. Eating Out Game u Nash equilibrium = Chinese, Chinese [4,2] u Nash equilibrium = Italian, Italian = [2,4] u 3 rd Nash equilibrium = ? (It’s there somewhere – I promise.) u Multiple equilibria!

56. 4. Examples of Games: Chicken “Game” Person j SwerveDon’t Swerve Person i Swerve(i=2,j=2)(i=1,j=4) Don’t Swerve (i=4,j=1)(i=0,j=0)

57. 4. Chicken “Game” u Nash equilibrium = Swerve, Don’t Swerve = [1,4] u Nash equilibrium = Don’t Swerve, Swerve = [4,1] u 3 rd Nash equilibrium = ? u Commitment mechanism?

58. 4. Examples of Games: Matching Pennies Game Person j HeadsTails Person i Heads(i=1,j=-1)(i=-1,j=1) Tails(i=-1,j=1)(i=1,j=-1)

59. 4. Matching Pennies Game u Nash equilibrium = ? u No pure strategy Nash equilibrium u Mixed strategy Nash equilibrium = 50%, 50% u Scissors, Rock, Paper: Mixed strategy Nash equilibrium = ?