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Canada (162,369)
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ECON 110 (199)
Chapter 11

Chapter 11 notes.docx

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ECON 110
Ian James Cromb

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Chapter 11: Imperfect Competition and Strategic Behaviour The Structure of the Canadian Economy Industries with Many Smaller Firms  About two-thirds of Canada’s total annual output is produced by industries made up of firms that are small relative to the size of the market they sell to o The perfectly competitive model does a good job at showing it – examples include raw materials and agriculture o However, some industries (retail trade and services) are not perfectly competitive since they have influence over prices – monopolistic competition Industries with Few Large Firms  About one-third of Canada’s annual output is produced by industries made up of firms that are dominated by either a single firm or a few large ones o The most striking cases of monopolies today are the electric utilities, telephone service providers, and TV and internet providers  Today, most modern industries that are dominated by large firms contain several firms o Called Oligopolies – the theory of oligopoly helps us understand industries which there are small numbers of large firms with market power, that actively compete Industrial Concentration  An industry with a small number of relatively large firms is said to be highly concentrated – a formal measure of such industrial concentration is given by the concentration ratio Concentration Ratios  When we measure whether an industry has power concentrated in the hands of only a few firms or dispersed over many, it is not sufficient to count the firms  We need to calculate the concentration ratio which shows the fraction of the total market sales controlled by the largest sellers, often taken as the largest four or eight firms o Firms may be large in an absolute sense, but a low concentration ratio suggests that they have quite limited market power Defining the Market  A problem with using concentration ratios is to define the market w. reasonable accuracy o On one hand, the market may be much smaller than the whole country – For example, concentration ratios in national cement sales are low, but they understate the market power of cement companies because high transport costs divide the cement industry into a series of regional markets, each having few firms o On the other hand, the market may be larger than one country, like internationally traded commodities  The globalization of competition brought about by the falling costs of transport and communication – the world is becoming “smaller” - large market sizes relative to the firm What is Imperfect Competition?  A large number of small firms that don’t follow the theory of perfect competition  A small number a large firms that don’t follow the theory of monopoly  The word imperfect emphasizes that we are not dealing with perfect competition, and the word competitive means that we are not dealing with monopoly  We’ll classify them under two main headings o Firms choose the variety of the product that they produce and sell o Firms choose the price at which they will sell that product Firms Choose Their Products  If a farmer enters the wheat market, the full range of products that they can produce is already in existence – in contrast, if a firm enters the cell phone industry, they must decide on the distinct characteristics of the new phone so it is differentiated  Differentiated Product: A group of commodities that are similar enough to be called the same product but dissimilar enough that all of them are not sold at the same price o Most firms in imperfectly competitive markets sell differentiated product Firms Choose Their Prices  Whenever firms’ products are not identical, each firm must decide on a price to set  Each firm that chooses the price at which their products are sold are called price setters o Price Setter: A firm that faces a downward-sloping demand curve for its product so it can choose which price to set  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 o In imperfect competition prices change less frequently than in perfect competition since all products are distinct from the others Non-Price Competition  Firms in imperfect competition behave in other ways that are not observed under either perfect competition or monopoly  First, many firms spend a large amount of money on advertising – to shift the industries demand curve and also to attract customers from competing firms  Second, many firms engage in a variety of other forms non-price competition, such as offering competing standards of quality and product guarantees o Many firms also compete through the services they offer along with their product  Third, firms in many industries engage in activities that appear to be designed to hinder the entry of new firms, thereby preventing the erosion of existing pure profits by entry o Price matching – may convince potential entrants not to enter the industry Monopolistic Competition  A market structure of an industry which there are many firms and freedom of entry & exit but in which each firm sells a differentiated product, giving it some control over price  Product differentiation leads to the establishment of brand names and advertising, and gives each firm a degree of market power over its own product  Each firm can raise their price, even if competitors don’t, without losing any sales – this is the monopolistic part of the theory  However, each firm’s market power is restricted in both the short and long run o In the short run there are a lot of similar prods – causes each D curve to be elastic o Long run restriction from free entry/exit-new firms competing for existing profits o This is the competition part of the theory Assumptions of Monopolistic Competition 1. Each firm makes one brand of the industry’s differentiated product – each firm faces a demand curve that is negatively sloped but is highly elastic because the many substitutes 2. Firms have access to the same technological knowledge and so have the same cost curves 3. The industry contains so many different firms that each ignores possible reactions of its competitors when it makes price/output decisions - Firms in M.P. similar to firms in P.C. 4. There is freedom of entry/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 products must be shared among more brands Predictions of the Theory  Product differentiation, the only thing which makes PC diff from MC, has important consequences for the behaviour of firms in MC in both the short run and long run The Short-Run Decision of the Firm  In the short-run, a firm that is operating in a monopolistically competitive market structure is similar to a monopoly  It faces a negatively sloped demand curve and maximizes its profits by equating marginal revenue with marginal cost The Long-Run Equilibrium of the Industry  Profits provide an incentive for new firms to enter, as they do the total demand for the industry’s products must be shared among a larger number of firms – everyone gets less o When firms enter the market, exiting firms’ demand curves shift to the left until the curve is tangent to the LRAC curve – maximizing profits, but profits are zero The Excess Capacity Theorem  Def: The property of long-run equilibrium in monopolistic competition that firms produce on the falling portion of their LRAC curves – this results in excess capacity, measured by the gap between present output and the output that corresponds with MES  Costs are higher in monopolistic competition but consumers value variety Empirical Relevance of Monopolistic Competition  Economists say that the monopolistically competitive market structure was almost never found in practice – since single product firms are rarely found in most industries o Typically, a vast array of products are produced by each firm in the industry  Industries like cereal (with Kellogg’s, General Mills, Post) are clearly not in perfect competition, but they are also not monopolies – and not in monopolistic competition Oligopoly and Game Theory  Oligopoly: An industry that contains two or more firms, at least one of which produces a significant portion of the industry’s total output – there is a high concentration ratio  An oligopolistic firm faces a few competitors – Each firms must realize that competitors may respond to anything that it does and should take possible responses into account – must be aware of each other’s interdependence in decision making  Economists say that oligopolistic firms exhibit strategic behavior, which means that they take explicit account of the impact of their decisions on competing firms and of the reactions they expect competing firms to make The Basic Dilemma of Oligopoly  There are similar incentives for oligopolistic firms to act in similar way as cartels, they face a similar dilemma as c
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