Competition and Market Structure

Frederick University 2011

Industry
Industry (market) a collection of firms, each of which is supplying products that have some degree of substitutability, to the same potential buyers Common buyers for sellers Common sellers for buyers Relatively homogeneous product

SCP Paradigm
Basic Conditions

Market Structure

Conduct

Performance

BASIC CONDITIONS

SUPPLY raw material technology product durability value/weight business attitudes unionization

DEMAND price elasticity rate of growth substitutes marketing type purchase method cyclical and seasonal character

Market Structure
Market Structure those characteristics of the market that significantly affect the behavior and interaction of buyers and sellers

MARKET STRUCTURE

number and size of sellers and buyers type of the product conditions of entry and exit transparency of information

Perfect Competition - structure

Many and small sellers, so that no one can affect the market Homogeneous product Free entry to and exit from the industry Transparent and free information

Pure Monopoly- market structure

Only one producer in the industry The product does not have close substitutes Blocked entry

Monopolistic competition structure

Many and small sellers Differentiated product Free entry and exit Transparent and free information

Oligopoly market structure

A) Tight oligopoly a few big firms in the industry with comparable market shares/ B) Dominant firm oligopoly one of the big firms in the industry is recognized as the price leader Homogeneous / Heterogeneous oligopoly Significant barriers to entry to and exit from the industry Significant barriers to information

Entry
Entry into an industry or to a segment of an industry can occur because there is de novo entry. takeover from outside the industry the development of technologically similar firms who develop their product range. the transference of brand names across sectors an increase in import penetration. Again, the scale of the firm involved is important here.

Barriers to Entry
Structural barriers High capital cost Economies of scale Product differentiation and brand loyalty High switching cost Ownership/control of key factors or outlets Strategic barriers Limit pricing Excess capacity Vertical integration Sleeping patents Predatory pricing Tying sales Institutional barriers Patents Regulations

Alternative Market Structures

The four market structures

perfect competition
monopoly

monopolistic competition
oligopoly

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Many / several

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, restaurants

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Cement cars, electrical appliances Local water company, train operators (over particular routes)

Pure Monopoly

One

Restricted or completely blocked

Unique

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Very Many

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, restaurants

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Cement cars, electrical appliances Local water company

Pure Monopoly

One

Restricted or completely blocked

Unique

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Very Many

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, restaurants

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Cement cars, electrical appliances Local water company

Pure Monopoly

One

Restricted or completely blocked

Unique

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Very Many

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, restaurants

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Cement cars, electrical appliances Local water company

Pure Monopoly

One

Restricted or completely blocked

Unique

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Very Many

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, convenience stores Cement cars, electrical appliances Local water company

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Pure Monopoly

One

Restricted or completely blocked

Unique

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Very Many

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, convenience stores Cement cars, electrical appliances Local water company

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Pure Monopoly

One

Restricted or completely blocked

Unique

Market Conduct
Market Conduct a firms policies toward its market and toward the moves made by its rivals in that market

CONDUCT

pricing behavior product strategy research and innovation advertising legal tactics

Perfect competition - conduct

Industrys market
P D S

Firms market
P 5 5 5 q 0 10 P 20 d TR 0 50 100 MR 5 5

Pe

MR

Qe

10

Q 20

Perfect competition short run conduct

p MC AC dd = MR Economic profit = (P-AC) q

P = MR

MC = MR P>AC

Perfect Competition long run conduct

Industrys equilibrium
P D S If P>AC, new firms start entering the industry and the equilibrium price falls.

Pe P

If < , the firms will start leaving the industry and the equilibrium price will increase.

Qe

The industry is in a long run equilibrium when P = AC In the long run the firms make normal profit

Perfect Competition - Deriving the short-run supply curve

P
P1 P2 P3 D1 D2 S a b c MC = S d1 = MR1 d2 = MR2 d3 = MR3

D3
Q (millions)

Q (thousands)

The firms short run supply curve is determined by its MC curve above AVC

(a) Industry

fig

(b) Firm

Long-run equilibrium of the firm (SR)MC under perfect competition

(SR)AC LRAC

DL AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

Pure Monopoly - conduct

P
D MC

P 10 9 8

Q 1 2 3

TR 10 18 24 P>MR

MR 10 8 6

P
Economic Profit

AC

MC=MR

Qm

MR

Pure Monopoly and Perfect competition

P
N

Consumer surplus = (P MWP) Under perfect competition = KLN MC Under pure monopoly = NRT Producer surplus = (P-MC) AC Under pure monopoly the producer surplus rises by KGTR at the expen of the consumer surplus T G L GTL the portion of the consumer surplus, which is a deadweight loss AR =society D for the JGL the portion of the producer surplus, which is a deadweight loss for the Q society

Pm
Pp.c.K

MR
Qm
Qp.c.

Monopolistic competition conduct in P>MR the short run

P

MC

MC = MR AC

Ps ACs

AR = D

MR
Qs

Monopolistic competition conduct in the long run If P>AC new firms will enter
P

the industry and the firms market segment will shrink - its individual demand curve shifts leftwards

LRMC LRAC
PL

ARL = DL

MRL

The long run equilibrium QL is achieved at P = AC, however, is not minimized there is excess capacity

Long run equilibrium under perfect competition and under monopolistic competition
P

LRAC P1 P2

DL under perfect competition

DL under monopolistic competition

Q1

fig

Q2

Tight oligopoly - conduct

P

NFD FD Q

The kinked demand curve under the tight oligopoly

NFD

P1

FD
Q1
fig

The kinked demand curve

P1
MRnf

a b
Q1

D = AR
Q

MRf

Rigid prices under the tight oligopoly

MC2

P1

MC1

b
Q1

D = AR
Q

MR

Price leadership of the dominant firm

P
Sothers

Dleader

Dindustry

Price leadership of the dominant firm P

MCleader Sother firms

PL

Dindustry
Dleader MRleader
QL QF QT Q

Market Performance
Market Performance how well does an industry do what society might reasonably expect it to do

PERFORMANCE

profitability allocative efficiency static production efficiency dynamic efficiency - progress full employment equity

Perfect Competition Performance

P = MR MC = MR P = MC P = AC AC = MC AC minimum

Perfect Competition Performance

Static Efficiency

The Perfect Competition achieves static efficiency

There is NO potential and motivation for innovations and technological progress

Efficiency in allocation Efficiency in motivation Efficiency in distribution

MC = P AC = MC AC = P

Dynamic Efficiency

The Perfect Competition does not achieve dynamic efficiency

Pure Monopoly - performance

Static efficiency

Efficiency in allocation Efficiency in motivation Efficiency in distribution AC < P

MC < P excess capacity

The pure monopoly does not achieve static efficiency

There is a potential and motivation for innovations and technological progress

Dynamic efficiency

The pure monopoly is motivated to achieve dynamic efficiency at the presence of potential competition

Monopolistic competition performance

Static Efficiency

Efficiency in allocation MC < P Efficiency in motivation excess capacity Efficiency in distribution AC = P

Contestable Markets
Key characteristics: Firms behaviour influenced by the threat of new entrants to the industry if even the industry is concentrated, the incumbent firms behave as if they are perfect competitors Firms performance depends on the potential competition

Contestable markets

Ultra easy entry Ultra easy exit Zero sunk cost Hit and run strategy

Contestable market

Oligopoly non-collusive behavior

Game theory the study of multi-person decision problems (the reactions of a few interdependent decision makers) Game - any situation that involves welldefined rules and outcomes, where outcomes are dependent on players strategic decisions Strategy a complete plan, specifying the game under any possible circumstances

The Prisoners dilemma

Two suspects, Valio and Georgy, are arrested by the police. The police have insufficient evidence for a conviction, and, having separated both prisoners, visit each of them to offer the same deal: if one testifies for the prosecution against the other and the other remains silent, the betrayer gets 3 months and the silent accomplice receives the full 10-year sentence. If both stay silent, both prisoners are sentenced to only 1 year in jail for a minor charge. If each betrays the other, each receives a three-year sentence. Each prisoner must make the choice of whether to betray the other or to remain silent. However, neither prisoner knows for sure what choice the other prisoner will make. So this dilemma poses the question: How should the prisoners act?

The Prisoners dilemma

Valios alternatives
Does not confess Does not confess Confesses
Georgy 10 years Valio 3 months Everyone gets 3 years

Georgys alterantives
Confesses

Everyone gets 1 year Georgy 3 months Valio- 10 years

fig

The Prisoners dilemma

The Prisoners dilemma is the duopolys dilemma. Prisoners cannot coordinate their confessions. Even though they both would get less if they do not confess, they betray the other player, because of the greater payoff. No matter what the other player does, one player will always gain a greater payoff by playing defect. Since in any situation playing defect is more beneficial than cooperating, all rational players will play defect.

Payoffs for firms A B under different pricing policies

As Price
2.00 1.80 5 for 12 for

2.00

10mil. for each

Bs Price
1.80 12 for 5 for
fig

8 for each

Collusive behavior

How could the firms overcome the prisoners dilemma?

Collusive behavior will set higher

prices for the buyers!