ECON 208 Chapter Notes - Chapter 11: Shampoo, Concentration Ratio, Game Theory

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Published on 16 Apr 2013
School
McGill University
Department
Economics (Arts)
Course
ECON 208
1
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
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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)
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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
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Document Summary

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. 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. 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.

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