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Chapter 11

Chapter 11 Imperfect Competition and Strategic Behaviour.docx

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Economics (Arts)
ECON 208
Mayssun El- Attar Vilalta

Chapter 11 Imperfect Competition and Strategic Behaviour 11.1 The Structure of the Canadian Economy Industries with Many Small Firms  2/3 of Canada’s total annual output  Perfectly competitive model: Individual firms produce more-or-less identical products and are price takers. (forest, fish, agriculture)  Others aren’t well described by the perfectly competitive model – retail trade and in service most firms have some influence over prices – spend money on advertising which is something price takers don’t do. Each store in these industries has a unique location that gives it some local market power over nearby customers  Monopolistic competition theory – many small firms, each with some market power Industries with a Few Large Firms  1/3 of Canada’s total annual output  Electric utilities, local telephone, cable/digital TV, internet – govt ownership or regulation  Market dominance by a single large firm is of the past; most modern industries that are dominated by large firms contain many firms  Oligopoly theory – small number of firms, each with market power, that compete actively w/ each other Industrial Concentration  An industry with a small number of relatively large firms = highly concentrated  A formal measure of such industrial concentration is given by the concentration ratio Concentration Ratios  Not enough to count the firms to find out how (in few firms or many)the power is concentrated  Concentration ratio: the fraction of total market sales/shipments (or some other measure of market activity) controlled by a specified number (4/8) of industry’s largest firms  The largest firms may be large in some absolute sense, but the low [] ratios suggest that they have limited market power Defining the Market  Problem with using [] ratios = to define the market w/ reasonably accuracy  Market may be much smaller than the whole country. []ratios in national cement sales are low, but they understate the market power of cement companies b/c high transportation costs divide the cement industry into a series of regional markets, with each having relatively few firm  The market may be larger than one country = most internationally traded products = []ratios (appropriately adjusted to define the relevant market correctly) can still be used to provide valuable info about the degree to which production in a given market is []ed in a few firms  Globalization due to falling costs of transportation and communication development in world economy = nature of domestic market has changed dramatically  Presence of a single firm in 1 industry in Canada doesn’t have monopoly power since in competition with foreign firms that can sell in Canadian market. These companies are large in the Canadian market but the relevant market is the global market in which these firms have no significant market power 1 11.2 What Is Imperfect Competition?  Many small firms – not in perfect competition – each firm has some market power  Some large firms – not a monopoly - each has considerable market power  Imperfectly competitive Firms Choose the variety of the Products  Either entering market where full range of products already exists (wheat); or, diff market where needs to develop variations on existing products or even a product with a whole new capability (cellphones) = selling differentiated products, no 2 of which are identical  Differentiated product: a group of commodities that are similar enough to be called the same product but dissimilar enough that they can be sold at different prices (shampoo)  Most firms in imperfectly competitive markets sell differentiated products. In such industries, the firm itself must choose which characteristics to give the products that it will sell. Firms Choose Their Prices  When diff firms’ products aren’t identical, each firm must decide on a price to set  Price setter: a firm that faces a downward-sloping demand curve for its product. It chooses which price to set. Each firm has expectations about the quantity it can sell at each price that it might set. Unexpected demand fluctuations cause unexpected variations in the Q sold at these P  In market structures other than perfect competition, firms set their prices and then let demand determine sales. Changes in market conditions are signalled to the firm by changes in the firm’s sales.  In perfect competition, P change continually in response to changes in D and S. (airline ticket)  In markets where differentiated products are sold, P changes less frequently because these firms have many distinct products on their P lists and changing long list of P is costly (cost of printing new list P and telling customers, hard to keep track of frequently changing prices for accounting and billing, loss of customer/retail goodwill since uncertainty cause by frequent changes in P). Imperfectly competitive firms respond to changes in D by changing output and holding P constant. If the changes in D are expected to persist, then firm adjust entire P list. Non-price Competition  Imperfect competition:  1) Many firms spend large sums of money on advertising to shift D curves for the industry’s products and to attract customers from competing firms  In perfectly competitive market, no advertising since firm faces perfectly elastic (horizontal) D curve at market price = advertising doesn’t increase revenues.  Monopolist has no competitors so doesn’t advertise to attract customers away from other brands, but sometimes advertises to try to convince consumers to shift their spending away from other types of products and toward the monopolist’s product  2) many firms engage in a variety of other forms of non-price competition (offering competing standards of quality and product guarantees; services they offer along with their products)  3) firms in many industries engage in activities that appear to be designed to hinder the entry of new firms, preventing the erosion of existing pure profits by entry (ex: match any price offered by competitor = convinces potential entrants not to enter industry) 2 Two Market Structures  Many small firms – monopolistic competition; Some large firms – oligopoly, game theory 11.3 Monopolistic Competition  monopolistic competition: market structure of an industry in which there are many firms and freedom of entry and exit but in which each firm has a product somewhat differentiated from the others, giving it some control over its price.  Perfect competition – sell identical product and are price takers  Product differentiation o establishment of brand names and advertising o firm has a degree of market power over its own product but it is restricted in SR (presence of similar products sold by many competing firms, causing the D curve faced by each firm to be very elastic) and LR (from free entry into the industry, permitting new firms to compete away the profits being earned by existing firms) (competition) o each firm can raise price, even if competitors don’t, w/o losing sales (monopolistic) The Assumptions of Monopolistic Competition 1. Each firm produces one specific brand of the industry’s differentiated product. Each firm faces a demand curve that, although negatively sloped, is highly elastic because competing firms produce many close substitutes. 2. All firms have access to the same technological knowledge and so have the same cost curves 3. The industry contains so many firms that each one ignores the possible reactions of its many competitors when it makes its own price and output decisions. In this respect, firms in monopolistic competition are similar to firms in perfect competition. 4. There is freedom of entry and exit in the industry. If profits are being earned by existing firms, new firms have an incentive to enter. When they do, the demand for the industry’s product must be shared among brands. Predictions of the Theory  Only difference between monopolistic and perfect competition = product differentiation The Short-Run Decision of the Firm (258)  Monopolistic competitive market in SR similar to monopoly: -vely sloped D curve, maximizes profits by equating MC with MR The Long-Run Equilibrium of the Industry  Profits provide incentive for new firms to enter the industry – total D for the product shared among the larger # of firms – each firm gets smaller share of total market - Entry shifts D curve faced by each existing firm to the left. Entry continues til profits stop and D curve is tangent to the LRAC curve, where each firm is maximizing its profit, but profit = 0. – tangency soln  1)If D curve below and never touches LRAC: no output at which costs could be covered and firms exit industry (until D curve for each remaining firm touches and is tangent to its LRAC curve). Fewer firms to share industry’s D, the D curve for each remaining firm shifts right.  2) If D curve for each firm cuts its LRAC curve – range of output over which +ve profits can be earned = firms enter industry, shifting D curve for each existing firm to the left til tangent to LRAC, so each firm earns 0 profit 3 The Excess-Capacity Theorem  Monopolistic competition = LR eq. of 0 profits even tho each firm has –ve sloping D curve  Forces each firm into a position in which it has excess capacity, each firm is producing an output less than that corresponding to the lowest point on its LRAC curve. If firm ^output, reduces cost/unit, but doesn’t do this selling more would reduce revenue by more than it would reduce cost = Excess-capacity theorem: the property of long-run equilibrium is monopolistic that firms produce on the falling portion of their long-run average cost curves. This results in excess capacity, measured by the gap between present output and the output that coincides with minimum average cost.  In the long-run equilibrium in monopolistic competition, goods are produced at a point where average total costs are not at their minimum.  LR eq. in perfect competition has price = minimum of LRAC  Theorem suggested that modern market economies were systematically inefficient due to product differentiation producing products at higher cost than necessary; but inefficiency has not been proven – not necessarily a waste of resources since some benefits accrue to consumers who can choose among the variety of products  Differences in tastes across many consumers that give rise to the social value of variety, and the price of that greater variety is the higher price per unit  From society’s point of view, there is a trade-off between producing more brands to satisfy diverse tastes and producing fewer brands at a lower cost per unit.  Monopolistic competition = wider range of products but higher cost/unit than perfect competition (which produces only one type of each generic product)  Product differentiation is only wasteful if the costs of providing variety exceed the benefits conferred by producing that variety Empirical Relevance of Monopolistic Competition  Usually many differentiated/competing products produced by each of the few large firms - not perfectly competitive or monopolies, not monopolistically competitive since contain few enough firms for each to take account of the others’ reaction when determining its own behaviour and these firms earn large profits w/o attracting entry – so oligopolgy  Monopolistic competition not applicable to differentiated products produced in industries w/ ^[], but still useful in analyzing industries in which [] ratios are low and products are differentiated (hair salons, gas stations) 11.4 Oligopoly and Game Theory  Oligopoly: an industry that contains two (duopoly) or more firms, at least one of which produces
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