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    Gsb728   lecture note topic 2b Gsb728 lecture note topic 2b Presentation Transcript

    • Economics for Management GSB728 Topic 4: Firms and Competition 1
    • Note: This lecture note was prepared based on the teaching material provided by the publisher of the textbook Principles of Economics. 2
    • Learning Objectives 1. The degree of competition - How much competition does a firm face? 2. Perfect competition – What happens when there are very many firms all competing against each other? Is this good for us as consumers? 3. Monopoly – What happens when there is only one firm in the market? Do we as consumers suffer? 4. Monopolistic competition - Assumptions. 3
    • Learning Objectives (contd.) 5. Oligopoly - What happens if there are just a few firms that dominate the market? Will they compete or get together? 6. Price discrimination - In what situations will firms be able to charge different prices to different consumers? How will we or consumers benefit or lose from the process? 4
    • The Degree of Competition • Classifying markets accordingly to: – Number of firms. – Freedom of entry to industry. – Nature of product. – Nature of demand curve. 5
    • The Degree of Competition (contd.) • The basic market structures: – Perfect competition – Monopoly – Monopolistic competition – Oligopoly • Structure Conduct Performance 6
    • Four Market Structures Source: Sloman et al. (2014). 7
    • Market Structures and Product Differentiation Source: Krugman & Wells (2013). 8
    • Perfect Competition • Assumptions: – Firms are price takers. – Freedom of entry. – Identical product. – Perfect knowledge of the market. • Short-run equilibrium of the firm: – Price, output and profit. 9
    • Derivation of Short-Run Profit Under Conditions of Perfect Competition $ $ Profit S D = AR = MR AR AC Pe AC MC D 0 0 Q (millions) (a) Industry Source: Sloman et al. (2014). Qe Q (thousands) (b) Firm 10
    • Derivation of Short-Run Loss Under Conditions of Perfect Competition AC $ $ MC loss S AC AR Pe D = AR = MR D 0 0 Q (millions) (a) Industry Source: Sloman et al. (2014). Qe Q (thousands) (b) Firm 11
    • Derivation of the Short-Run Supply Curve S P $ MC = S a P1 b P2 c P3 D1 = MR1 D2 = MR2 D3 = MR3 D1 D3 O D2 O Q (millions) (a) Industry Source: Sloman et al. (2014). Q (thousands) (b) Firm 12
    • Perfect Competition: Long Run Equilibrium • Long-run equilibrium of the firm: – Supernormal profits eventually eliminated through competition as new firms enter the market. – LRAC = (SR)AC = MC = MR = AR 13
    • Long-Run Equilibrium Under Perfect Competition P New firms enter and supply moves to the right S1 to Se $ S1 Se At P1(=AR1 = D1) supernormal profits (P1 > LRAC) but entry of new firms forces price down to PL(=ARL= DL) and Supernormal profits are eventually eliminated. LRAC P1 ARL P1 PL D1 DL D 0 0 Q (millions) (a) Industry Source: Sloman et al. (2014). QL Q (thousands) (b) Firm 14
    • Perfect Competition Long-Run Equilibrium of the Firm (SR)MC $ (SR) AC LRAC D = AR = MR Equilibrium = LRAC = (SR)AC =(SR)MC = MR =AR 0 Source: Sloman et al. (2014). Q 15
    • Growth of an Industry After a Shift in Demand Source: Taylor and Frost (2009). 16
    • Perfect Competition (contd.) • Incompatibility of perfect competition and substantial economies of scale: When firms expand to achieve economies of scale they usually gain market power (undercut prices to decrease competition). • Is perfect competition good for consumers? – Price equals marginal cost (efficient). – Prices kept low (firms operate at minimum LRAC). – Firms must be efficient to survive. 17
    • Monopoly • Monopoly exists when: 1) there is only one firm in the industry 2) selling a particular product and 3) there are barriers to entry. • Barriers to entry: – Economies of scale. – Product differentiation and brand loyalty. – Lower costs for an established firm. – Ownership/control of key production factors. – Ownership/control over inputs or outlets. – Legal protection. – Mergers and takeovers. – Aggressive tactics. 18
    • Monopoly (contd.) • The monopolist’s demand curve is: – Downward sloping. – MR falls below AR. • Equilibrium price and output: – Equilibrium output achieved where MC = MR. – Equilibrium price given by the demand curve. 19
    • Profit Maximisation Under Monopoly $ MC P = AR AR 0 Source: Sloman et al. (2014). MR Qm Q 20
    • Monopoly (contd.) • Profit: – Supernormal profit can persist in long run. 21
    • Profit Maximisation Under Monopoly $ MC Total profit AC AR AC AR 0 Source: Sloman et al. (2014). MR Qm Q 22
    • Profit Maximisation Under Monopoly Source: Pindyck & Rubinfeld (2013). 23
    • Monopoly (contd.) • Monopoly versus perfect competition: which best serves the public interest? – Short-run price and output • Monopoly: high prices/low output: short run – Long-run price and output • Monopoly: high prices/low output: long run 24
    • Comparison of Industry Equilibrium: Monopoly and Perfect Competition Assuming same MC curve MC ( = supply under Monopoly equilibrium restricts output and maximises price. $ perfect competition) Equilibrium under perfect competition gives lower price and increased output. P1 P2 AR = D MR monopoly O Source: Sloman et al. (2014). Q1 Q2 AR=D=MR under perfect competition. Q 25
    • Monopoly (contd.) • Monopoly versus perfect competition: which best serves the public interest? – Costs under monopoly: • Costs may be higher - barriers to entry. • Costs may be lower - economies of scale. – Super-normal profit for research and development and investment. – Competition for corporate control. – Innovation and new products. 26
    • Comparison of Industry Equilibrium Monopoly and Perfect Competition Differing MC curves (I) $ MC monopoly P1 AR = D MR monopoly 0 Source: Sloman et al. (2014). Q1 Q 27
    • Comparison of Industry Equilibrium Monopoly and Perfect Competition Differing MC curves (II) $ MC perfect competition ( = supply) MC perfect competition ( = supply) MC monopoly Q1 Produced MC monopoly P2 Q3 Produced P1 P3 AR = D =MR perfect competition MR monopoly 0 Q2 Source: Sloman et al. (2014). Q1 Q3 Q4 Q 28
    • Theory of Contestable Markets • A perfectly contestable market has three main features: – No entry or exit barriers. – No sunk costs (costs that cannot be recouped). – Access to the same level of technology. 29
    • Theory of Contestable Markets (contd.) • Theory of contestable markets: – Relevance of potential competition (threat of competition). – How contestable is the market? (is there free and costless entry and exit). – Contestable markets and natural monopolies (economies of scales and size of the market affect contestability of markets). – Importance of costless exit (absence of sunk costs, which cannot be recouped). • Contestability and the consumer’s interest. 30
    • Monopolistic Competition • Assumptions of monopolistic competition: • Large number of firms. • Interdependence. • Freedom of entry. • Product differentiation. – Examples in Australia: • Petrol stations, hairdressers, restaurants, breakfast cereals, soft drinks, etc. 31
    • Monopolistic Competition Short-Run Equilibrium of the Firm MC $ AC Ps Economic profit ACs AR D MR 0 Source: Sloman et al. (2014). Qs Q 32
    • Monopolistic Competition Long-Run Equilibrium of the Firm $ LRMC LRAC PL AR D MR 0 Source: Sloman et al. (2014). QL Q 33
    • Monopolistic Competition • Non-price competition: • Product development/differentiation. • Advertising. • The public interest: – Comparison with perfect competition: • Less will be sold and at a higher price. • Firms will not be producing at the least-cost point (due to excess of capacity). • Difference in price expected to be small. • Variety of products to choose from. – Comparison with monopoly: • More will be sold at lower prices (more competition). 34
    • Perfect and Monopolistic Competition Long-Run Equilibrium of the Firm Contrasted $ Long-run equilibrium under monopolistic competition Long-run equilibrium under perfect competition LRAC P1 P2 DL perfect competition DL monopolistic competition 0 Source: Sloman et al. (2014). Q1 Q2 Q 35
    • Oligopoly • Key features of oligopoly: – Barriers to entry. – Interdependence of the firms. • Examples in Australia: – Motor vehicle industry, banking industry, supermarket . 36
    • Is the Australian’s Banking Sector Under Oligopoly? Banks’ % Share of Total Bank Assets Bank Commonwealth National Australia Westpac ANZ Sub-total – four largest banks All other banks Total – all banks Source: Sloman et al. (2014). % 18.6 18.2 15.2 14.6 66.7 33.3 100.0 37
    • Oligopoly (contd.) • Decision: Competition or collusion. • Non-Collusive oligopoly: Oligopolists have no agreement between themselves, formal, informal or tacit. • Collusive oligopoly: Oligopolists agree formally or informally to limit competition between them. – They must set quotas, fix prices, limit product promotion or development, or agree to respect each other’s market share. – Cartel: Formal collusive agreement. 38
    • Profit-Maximising Oligopolistic Cartel $ MC industry P1 D industry AR industry MR industry 0 Q1 Source: Sloman et al. (2014). Q 39
    • Oligopoly (contd.) • Cartels: – Equilibrium of the industry: Similar to monopoly. Quantity will be reduced to increase prices and profits of members of the cartel. How? – Allocating and enforcing quotas (production or sell quota set by a cartel): Output that each member of a cartel is allowed to produce or sell. – Example: The Organisation of Petroleum Exporting Countries (OPEC). 40
    • Oligopoly (contd.) • Tacit collusion: – Dominant firm price leadership. – Barometric firm price leadership. – Other forms of tacit collusion: • Average cost pricing. • Price benchmark (reference price). 41
    • Oligopolistic Price Leader Aims to Maximise Profits for a Given Market Share (I) $ Price leader has major market share and sets market price EL PL MC leader Market follows price leader EM D market = AR market D leader = AR leader MR leader 0 Source: Sloman et al. (2014). QL QM Q 42
    • Oligopolistic Price Leader Aims to Maximise Profits for a Given Market Share (II) $ Leader drops price MC leader PL (=M) EL EM Market may retaliate price war! EL1 PL1 D market = AR market D leader = AR leader Leader increases market share MR leader 0 Source: Sloman et al. (2014). Q L Q L1 QM Q 43
    • Oligopoly (contd.) • Factors favouring collusion: – Few firms. – Open with each other about costs and production methods. – Similar production methods and average costs. – Similar products. – There is a dominant firm. – Significant entry barriers. – The market is stable. – No government measures to stop collusion (Antitrust laws in US, Europe and Australia’s Competition and Consumer 44 Commission – ACCC: http://www.accc.gov.au/).
    • Oligopoly (contd.) • Non-collusive oligopoly: firms decide do not cooperate. • Game theory – Alternative strategies including: • Maximin (choosing the strategy whose worst possible outcome is the least bad) and Maximax (choosing the strategy that has the best possible outcome). – Simple dominant strategy games: • The prisoners’ dilemma. • Nash equilibrium (position resulting from everyone making their optimal assumptions about their rival’s decisions). – The importance of threats and promises. – The importance of timing of decisions. • Decision trees/First mover advantage/disadvantage. 45
    • Game theory: Profits for Firms X and Y at Different Prices X’s price $2.00 B A $2.00 $1.80 $5m for Y $12m for X $10m each Y’s price D C $1.80 Source: Sloman et al. (2014). $12m for Y $5m for X $8m each 46
    • The Prisoners’ Dilemma Sue's alternatives Not confess Not confess Bill's alternatives Confess Source: Sloman et al. (2014). Confess B A Each gets 1 year C Bill gets 3 months Sue gets 10 years Bill gets 10 years Sue gets 3 months D Each gets 3 years 47
    • Decision Tree Boeing –$10m Airbus –$10m Boeing decides A (3) Boeing –$10m Airbus –$10m (4) or or B2 Airbus decides Source: Sloman et al. (2014). (2) Boeing +$50m Airbus +$30m B1 (1) Boeing +$30m Airbus +$50m Airbus decides or 48
    • Kinked Demand for an Oligopolistic Firm (I) $ Current price and quantity give one point on demand curve. P1 D market O Source: Sloman et al. (2014). Q1 Q 49
    • Kinked Demand for an Oligopolistic Firm (II) $ P1 a Lowering price below market equilibrium ‘a’ will cause other firms to follow thus reducing elasticity of demand. D market O Source: Sloman et al. (2014). Q1 Q 50
    • Kinked Demand Curve Promotes Price Stability $ MC2 E1 P1 MC1 a D b O Source: Sloman et al. (2014). Q1 MR AR Q 51
    • Oligopoly (contd.) • Oligopoly and the consumer: – Collusion is negative for consumers. Some disadvantages like less scope for economies for economies of scale. – Some advantages are: • Oligopolists could use part of their abnormal profits for research and product development/Non-price competition. Also price stability. – Countervailing power (market power of a seller is offset by powerful buyers who can prevent the price to raise. – Difficult to draw general conclusions. 52
    • Price Discrimination • Price discrimination: A firm sells the same product at different prices. – First degree • Approximate examples in Australia could include bargaining at market stalls, and some services. – Second degree • Examples in Australia include water, electricity, bulk buying. – Third degree (the most common form) • Examples in Australia include cinema tickets, airline tickets, rail and bus tickets. 53
    • Price Discrimination (contd.) • Conditions necessary for price discrimination: • Firms must be able to determine own price (not price takers). • Separate markets (not possibility of resell or arbitrage). • Differing demand elasticities between markets. 54
    • Third-Degree Price Discrimination (I) $ Revenue from a single Price 200 x $10 = $2,000 10 D O Source: Sloman et al. (2014). 200 Q 55
    • Third-Degree Price Discrimination (II) $ A high discriminatory price of $20 is now introduced at which 150 units are sold, giving revenue of 150 x $20 = $3, 000 20 With price discrimination, total revenue is increased from $2,000 to $3,500 10 D Revenue from previous price now (200-150) x 10 = $500 O Source: Sloman et al. (2014). 150 200 Q 56
    • Price Discrimination (contd.) • Advantages of Price discrimination to the firm: • Higher revenue. • Used to drive competitors out of business in specific markets. • Used to subsidise predatory pricing (selling at a price below average variable cost in order to drive competitors out of the market) in a particular market. 57
    • Profit-Maximising Output Under Third-Degree Price Discrimination Total revenue with price discrimination = $23,000 $ MCY MCX MCT 9 7 DY 5 MRX 0 1,000 0 (a) Market X TR = $9 x 1,000 = $9,000 Source: Sloman et al. (2014). MRT MRY DX 2,000 (b) Market Y 0 3,000 (c) Markets X + Y TR = $7 x 2,000 = $14,000 58
    • Price Discrimination (contd.) • Price discrimination and the consumer: – Not clear-cut decision can be made (some consumers might benefit while other might loose). 59
    • References Krugman, P. and Wells, R. (2013). Economics (3rd ed.). New York: Worth Publishers. Morales, L. E., Simons, P. and Valle de Souza, S. (2014). GSB728: Economics for Management [Topic Notes]. Armidale, Australia: University of New England, Graduate School of Business. Pindyck, R. and Rubinfeld, D. (2013). Microeconomics (8th ed.). New Jersey: Pearson. 60
    • References (contd.) Sloman, J., Norris, K and Garratt, D. (2014). Principles of Economics (4th ed.). French Forest, Australia: Pearson. Taylor, J. and Frost, L. (2009). Microeconomics (4th ed.). Milton, Australia: John Wiley & Sons. 61