2731L78.ppt

ECW2731
Weeks 7 & 8
Weeks 7 & 8
Competition, market structures
and
business decisions

ECW2731
Weeks 7 & 8
Examination structure
1. Exam duration 120 minutes writing time
2. Reading time 10 minutes
3. Total number of questions 5
4. Students must attempt all questions
5. Use of calculators is permitted
Please note, original hand written notes or
computer printouts or photocopies are not
permitted in the exam this year.

ECW2731
Weeks 7 & 8
Examination structure
Section 1. (Microeconomic theory from the Managerial
Perspective) – attempt
Q 1-4
Four theoretical questions. May include discussion of examples. Brief
answers are expected including definitions and diagrams where approporiated
and/or specifically asked for.
Section 2. (Research Question) –attempt only one question 5
or 6
5. “Discuss possible impact of the introduction of carbon emission trading
scheme in Australia on the following industries:
Electricity generation
Car manufacturing and import
Tourism and hospitality
Forestry
6. Apply question 5 to any country of your choice.

ECW2731
Weeks 7 & 8
Weeks 7-8
Competition,
market structures and
business decisions
Structure
Managerial
Economics
Weeks 5 - 6
Production and Costs
Week 2
Basic economics principles:
demand and supply.
Week1
Introduction. The nature
of managerial economic
decision making
Week 9
Pricing strategies and
practices
Week 10
Business and Government.
Week 11
Capital budgeting
Week. 12
Research question
Business and current
economic situation.
Weeks 3-4
Demand analysis
and estimation

ECW2731
Weeks 7 & 8
What is the market Structure
Competition, market structures and
business decisions
How does competition affect
business decisions in different
market structures?
Perfect competition; monopoly;
oligopoly; monopolistic
competition
Competitive strategies.
Measurement of market structures
Market strategies in different
market structures.
Non-price competition.
Multinational companies. Vertical
and horizontal coordination.
Learning objectives

ECW2731
Weeks 7 & 8
Competition, market structures and business decisions
Reading
Hirschey, Chapters 10, 12, 13, & 14

ECW2731
Weeks 7 & 8
7
Table 10.1 Characteristics of Market Types
Market
structure
Examples
Number
of
producers
Type of
product
Power of
firm over
price
Barriers
to entry
Non-price
competition
Perfect
competition
Parts of
agriculture are
reasonably close
Many Standardized None Low None
Monopolistic
competition
Retail trade Many Differentiated Some Low
Advertising and
product
differentiation
Oligopoly
Computers, oil,
steel
Few
Standardized or
differentiated
Some High
Advertising and
product
differentiation
Monopoly Public utilities One Unique product
Consider-
able
Very high Advertising

ECW2731
Weeks 7 & 8
Market structures
What is the market structure?
• The competitive environment in the market for
any product is the market structure faced by the
firm
– Is measured in terms of
• the number of the actual buyers and sellers plus potential
entrants
• Barriers to entry and exit
• Capital requirements
• Price vs Non-price competition
• Etc
– Potential entrants pose a sufficiently credible threat of
entry to affect price/output decisions of incumbents

ECW2731
Weeks 7 & 8
Factors that Shape the Competitive
Environment
• Product Differentiation
– R&D, innovation, and advertising are important in
many markets.
• Production Methods
– Economies of scale can preclude small-firm size.
• Entry and Exit Conditions
– Barriers to entry and exit can shelter incumbents
from potential entrants.
• Buyer Power
– Powerful buyers can limit seller power.
Market structures

ECW2731
Weeks 7 & 8
Market structures
Perfect competition
Oligopoly
The firm in competitive markets
Monopoly
Non-perfect competition
Monopolistic competition

ECW2731
Weeks 7 & 8
Market structures “Perfect competition” – competitive markets
 Profit maximiser
 Identical product
 Very small share of the market
 Price-taker
 Produces a homogeneous product
 Perfect information
 No barriers to entry (legal, technological, or
resource)
 No technical progress
 No investment lag - Immediate implementation of
production decisions)
 Homogeneous goals of the owners and
managerial staff

ECW2731
Weeks 7 & 8
• Examples of Competitive Markets
– Agricultural commodities.
– Some prominent markets for intermediate goods and
services.
– Unskilled labor market.

ECW2731
Weeks 7 & 8
• Profit Maximization Imperative
– Normal profit is return necessary to attract and maintain
capital investment.
– Efficient firms can earn normal profit.
– Inefficient firms suffer losses.
• Role of Marginal Analysis
– Set Mπ = MR – MC = 0 to maximize profits.
– MR=MC when profits are maximized.

ECW2731
Weeks 7 & 8
14
Profit maximization in a perfectly
competitive market
• (see book)
• P = MC
• Marginal cost curve left of shutdown level (min. variable cost) is supply
curve
• P = MR = MC = AC
• Firm produces at minimum of average costs! (optimal outcome for
industry)
• In a constant-cost industry increase in supply will lead in the long term to
constant prices (i.e. horizontal supply curve)

ECW2731
Weeks 7 & 8
Marginal Cost and Firm Supply
Short-run Firm Supply
– Competitive market
price (P) is shown as a
horizontal line because
P=MR.
– Firm’s marginal-cost
curve shows the amount
of output the firm would
be willing to supply at
any market price.
– Marginal cost curve is
the short-run supply
curve so long as P >
AVC .

ECW2731
Weeks 7 & 8
Long-run Firm Supply
Marginal cost
curve is the
long-run supply
curve so long
as P > ATC.
In long run, firm
must cover all
necessary costs
of production
and earn a
normal profit.

ECW2731
Weeks 7 & 8
Long Run Normal Profit
Equilibrium
With a horizontal market
demand curve, MR=P.
P=MR=MC=ATC.
There are no economic
profits.
All firms earn a normal
rate of return.

ECW2731
Weeks 7 & 8
Price, cost
Market structures Perfect competition
Breakeven point
Output per time period
MC
ATC
AVC
0
D
B
per unit
Qoff peak
Q peak
Poff peak
Ppeak
Poff peak – break even
price off peak. At this
price the firm expects
to return only variable
costs and can produce
quantity Qoff peak
Ppeak- break even price at
peak. This is when the
firm expects to return
both fixed and variable
costs producing
quantity Qpeak

ECW2731
Weeks 7 & 8
Competitive Market Supply Curve
Market Supply With a Fixed
Number of Competitors
Supply is the sum of
competitor output.
Market Supply With Entry and Exit
Entry results in more firms,
increased output, a
rightward shift in the
supply curve, and drives
down prices and profits.
Exit reduces the number of
firms, decreases the
quantity of output, shifts
the supply curve leftward,
and allows prices and
profits to rise for remaining
competitors.

ECW2731
Weeks 7 & 8
Quantity per time period (millions)
10
8
6
4
2
0
Supply
50 100150200250300350400
Price per
unit ($)
P=–$0.254 + $0.000025
Q
P= $40
–$0.0001
Q
Demand
Market structures Perfect competition
Market price
determination
• Negatively sloped demand
curve
• Positively sloped supply
curve

ECW2731
Weeks 7 & 8
Market structures Monopoly
Basic Properties
• One firm in industry
• Profit-maximiser
• Faces market demand curve
• One product
• No close substitutes
• Price-maker
• No restrictions on resources
• Blockaded entry and/or exit
• Imperfect dissemination of information
• Opportunity for economic profits in long-run equilibrium.

ECW2731
Weeks 7 & 8
• Examples of Monopoly
– Electricity utilities,
– Gas
– Water
– Public Tramsport
– Telecommunications

ECW2731
Weeks 7 & 8
23
Monopoly graph

ECW2731
Weeks 7 & 8
Profit Maximization in Monopoly Markets
• Price/Output Decisions
• A monopoly firm is the
market.
• Market and firm demand
curve slopes downward.
• Monopoly demand curve
is always above the
marginal revenue curve,
P = AR > MR.
• Monopoly position allows
above-normal profits.
P > AC in long-run
equilibrium.
• Set Mπ = MR - MC = 0 to
maximize profits.
• MR=MC at optimal
output.

ECW2731
Weeks 7 & 8
Social Costs of Monopoly
• Monopoly Underproduction
Monopolists produce too
little output.
Monopolists charge prices
that are too high.
• Deadweight Loss from
Monopoly
Monopoly markets creates
a loss in social welfare
due to the decline in
mutually beneficial trade
activity.
There is also a wealth
transfer problem
associated with
monopoly.
Under monopoly,
consumer surplus is
transferred to
producer surplus.

ECW2731
Weeks 7 & 8
Social Benefits From Monopoly
• Economies of Scale
Monopoly is sometimes the natural result of vigorous
competitive forces.
In natural monopoly, LRAC declines continuously and one
firm is most efficient.
Some real-world monopolies are government-created or
government-maintained.
• Invention and Innovation
Public policy sometimes confers explicit monopoly rights to
spur productivity.

ECW2731
Weeks 7 & 8
Monopoly Regulation
• Dilemma of Natural Monopoly
Monopoly has the potential for efficiency.
Unregulated monopoly can lead to economic profits and
underproduction.
ECW3830 COMPETITION AND REGULATION

ECW2731
Weeks 7 & 8
28
Monopolists produce less, price higher than
firms in competitive equilibrium
MR = P(1 + 1/h)
• Situation is inefficient, insofar as the sum of
consumer and producer surplus is concerned
– What is producer and consumer surplus?
• Monopolist has to take demand conditions
explicitly into account
• Why is no other firm entering the market???

ECW2731
Weeks 7 & 8
29
Other aspects of monopoly
• “Natural monopoly” if minimum of average cost
occurs only at very high output level (minimum
efficient scale) ==> there is only place for one
firm in the market!
• Measure of monopoly power (markup of price
over cost):
P MC
markup
MC



ECW2731
Weeks 7 & 8
30
Sources of monopoly power
• Natural monopoly (public utilities best example, railway tracks), economies
of scale,
• Capital requirements on production or big sunk costs on entry
• Patents (17 years), trade secrets (Coke)
• Exclusive or unique assets (minerals, talent)
• Locational advantage (popcorn shop in cinema – but in general you pay
rent for these advantages)
• Regulation (TV, taxi, telephone in the past)
• Collusion by competitors

ECW2731
Weeks 7 & 8
Market structures In the “real life”
• A typical firm, if it is not a small one, is not owner-managed
• Separation of ownership, long-term strategic and short-run
current control (shareholders, board of directors, brunch
managers) implies the segregation of objectives;
• Natural, economic and legal barriers
• Diversification (non-homogenous product, more than one kind of
activity)
• Technical progress
• Different criteria for different time horizons (short-run operation
vs long-run planning.
• Price-making
• Price/marketing strategies
• Imperfect information
• Investment lag
A “real” firm in a market place
(compare to the “ideal” one):

ECW2731
Weeks 7 & 8
34
Sources of monopoly power
• Natural monopoly (public utilities best example, railway tracks), economies
of scale,
• Capital requirements on production or big sunk costs on entry
• Patents (17 years), trade secrets (Coke)
• Exclusive or unique assets (minerals, talent)
• Locational advantage (popcorn shop in cinema – but in general you pay
rent for these advantages)
• Regulation (TV, taxi, telephone in the past)
• Collusion by competitors

ECW2731
Weeks 7 & 8
35
What can a monopolist do?
Erect strategic entry barriers
• Excessive patenting and copyright
• Limit pricing (set price below monopoly price)
• Extensive advertising to create brand name to
raise cost of entry
• Create intentionally excess capacity as a warning
for a price war

ECW2731
Weeks 7 & 8
36
Franchising „McFood“
• A Franchiser (mother company) gets a fixed
percentage of sales,
• The franchisee is the residual claimant
• What are the incentives for the two partners?
• Other problems like number of shops in a region…
• Other examples??

ECW2731
Weeks 7 & 8
Contrast Between Monopolistic Competition
and Oligopoly
• Monopolistic Competition
• Large number of sellers that offer differentiated products.
• Normal profit opportunity in long-run equilibrium.
• Oligopoly
• Few sellers.
• Economic profits are possible in long-run equilibrium.
• Dynamic Nature of Competition
• Timely market structure information is required for
managerial investment decisions
Market structures Oligopoly and Monopolistic Competition

ECW2731
Weeks 7 & 8
Market structures Мonopolistic competition
• The market consists of n mono-product firms;
• The products are viewed by the buyers as close though not
perfect substitutes for one another;
• Therefore, each of the sellers is a monopolist of its particular
product variant with a limited degree of monopoly power.
• Such a monopolist is enjoying a monopoly power and making
economic profit during only a short period of time
• from the introduction of an unique product or technology
• until such a technology becomes available to rivals, or
• until a new “more innovative” product is introduced by a
rival.

ECW2731
Weeks 7 & 8
Q
Short-run Monopoly Equilibrium
Monopolistically competitive firms take
full advantage of short-run monopoly.
Price
Costs
Quantity
MR Demand
MC
AC
Qmc
Pmc

ECW2731
Weeks 7 & 8
Long-run equilibrium same costs, lower demand
and excess capacity – low output high price
decision With differentiated products, P=AC at a
point above minimum LRAC.
P > MR = MC.
Price
Costs
Quantity
MR1
D1
MC AC
MR2
D2
Price
Costs
Quantity
MC AC
Pmc
Qmc
MR
D
Entry of new firms offering
product substitutes shifts
the demand and MR curves)

ECW2731
Weeks 7 & 8
Long-run equilibrium– high output low price
decision (corresponds to perfect
Competition)
With homogenous products, P=AC at minimum
LRAC.
This is a competitive market equilibrium
with homogeneous production.
Price
Costs
Quantity
MR1
D1
MC AC
MR2
D2
Price
Costs
Quantity
MC AC
Pm
c
Qmc
MR
D
Qac
Pac
Long-run equilibrium same costs, lower
demand and excess capacity – low
output high price decision
With differentiated products, P=AC
at a point above minimum LRAC.
P > MR = MC.

ECW2731
Weeks 7 & 8
• Oligopoly Market Characteristics
• Few sellers.
• Homogenous or unique products.
• Blockaded entry and exit.
• Imperfect dissemination of information.
• Opportunity for above-normal (economic) profits in long-run
equilibrium.
• Examples of Oligopoly
• National markets for aluminum, cigarettes, electrical
equipment, filmed entertainment, ready-to-eat cereals, etc.
• Local retail markets for gasoline, food, specialized services,
etc.
Market structures Oligipoly

ECW2731
Weeks 7 & 8
Cartels and Collusion
• Overt and Covert Agreements
• Cartels operate under formal agreements.
• Powerful cartels function as a monopoly.
• Collusion exists when firms reach secret, covert
agreements.
• Enforcement Problem
• Cartels are typically rather short-lived because coordination
problems often lead to cheating.
• Cartel subversion can be extremely profitable.
• Detecting the source of secret price concessions can be
extremely difficult.

ECW2731
Weeks 7 & 8
Cartels and Collusion

ECW2731
Weeks 7 & 8
Oligopoly Output-Setting Models
• Cournot Oligopoly
• Cournot equilibrium
output is found by
simultaneously solving
output-reaction curves
for both competitors.
• Cournot equilibrium
output exceeds
monopoly output but is
less than competitive
output.

ECW2731
Weeks 7 & 8
Stackelberg Oligopoly
• Stackelberg model posits a first-mover advantage.
• Price wars severely undermine profitability for both leading
and following firms.
• Price signaling can reduce uncertainty in oligopoly markets.
• Price leadership occurs when firms follow the industry
leader’s pricing policy.

ECW2731
Weeks 7 & 8
Stackelberg Oligopoly
• Price leader sets
the price at P2
• Profit is maximised
at Q1.
• The follower(s) will
supply the
combined output of
Q4-Q1
• At P3- Follows will
supply everything
At P1 – the leader will
supply everything
at no economic
profit

ECW2731
Weeks 7 & 8
Oligopoly Price-Setting Models
• Bertrand
Oligopoly: Identical
Products
– The Bertrand
model focuses
upon the price
reactions.
– The Bertrand
model predicts a
competitive
market
price/output
solution in
oligopoly
markets with
identical
products.

ECW2731
Weeks 7 & 8
• Types of Games
– Zero-sum game: offsetting gains/losses.
– Positive sum game: potential for mutual gain.
– Negative-sum game: potential for mutual loss.
– Cooperative games: joint action is favored.
• Role of Interdependence
– Sequential games: moves in succession.
– Simultaneous-move game: coincident moves.
• Strategic Considerations
Market structures Game Theory Basics

ECW2731
Weeks 7 & 8
Prisoner’s Dilemma
• Classic Riddle
– Rational behavior can give suboptimal result.
– Rationality can hamper beneficial cooperation.
• Business Application
– Dominant strategy gives best result regardless of moves by
other players.
– Secure strategy gives best result assuming the worst
possible scenario.
• Broad Implications

ECW2731
Weeks 7 & 8
Nash Equilibrium
• Nash Equilibrium Concept
– Neither player can improve their payoff through a unilateral
change in strategy.
– Nash equilibrium concept is broader than the concept of a
dominant strategy equilibrium.
– Every dominant strategy equilibrium is also a Nash
equilibrium.
– Nash equilibrium can exist where there is no dominant
strategy equilibrium.
• Nash Bargaining

ECW2731
Weeks 7 & 8
Infinitely Repeated Games
• Role of Reputation
– Infinitely repeated games occur over and over again without
boundary or limit.
– Firms receive sequential payoffs that shape current and
future strategies.
– Reputations for high quality give consumers confidence for
repeat transactions.
• Product Quality Games
– In a one-shot game, poor quality can fool customers.
– In an infinitely repeated game, poor quality is shunned by
customers.

ECW2731
Weeks 7 & 8
Finitely Repeated Games
• Uncertain Final Period
– Finitely repeated games have limited duration.
– With end point uncertainty, a finitely repeated game mirrors
an infinitely repeated game.
• End-of-game Problem
– Enforcing end-of-game performance is difficult.
– Solution: simply extend the game!
• First-mover Advantages
– Benefits earned by the player able to make the initial move
in a sequential move or multistage game.

ECW2731
Weeks 7 & 8
Competitive strategies in Imperfectly competitive markets
 Not all industries offer the same potential
for sustained profitability;
 Not all firms are equally capable of
exploring the profit potential that is
available.
 An effective competitive strategy in
imperfectly competitive markets must be
founded on the firms competitive
advantage.

ECW2731
Weeks 7 & 8
 A competitive advantage is a unique or rare ability to
create, distribute or service valued by customers.
It is a business-world analogue to what economists
call comparative advantage or when one nation or
region of the country is better suited to the
production of one product than to the production of
some other product
 Above-normal rate of return require a competitive
advantage that cannot easily be copied
In production;
In distribution; or
In marketing

ECW2731
Weeks 7 & 8
 Reasons for competitive advantage:
 Access to a unique resource
 (Exclusive) Access to a mineral deposit
 (Exclusive) Access to a material
 Efficient energy source
 Unique climatic condition
 Unique technology
 Unique (specially qualified or very talented) labour
force; or
 Access to a unique market
 A university bookshop
 The rice market in Japan
 etc

ECW2731
Weeks 7 & 8
Product differentiation
refers to the increase in time of the number of
product categories suppled and the number of items
in each category
 Historically, a step from oligopolistic to monopolistic
competition

ECW2731
Weeks 7 & 8
A simple model of the reason for product differentiation
Price
Quantity
Q
P
P*
• Considers constant
quantity as well as non-
changing AC and MC
corresponding to this
quantity
• Producing a little bit
different product a firm
might hope to charge a
higher price

ECW2731
Weeks 7 & 8
Barriers to entry
Price
Quantity
Q
P
P*
LAC
LAC*
Absolute cost advantages:
Ability of established firms to
produce any given level of output
at lower unit costs than potential
entrants
Q*

ECW2731
Weeks 7 & 8
Price
Quantity
Q*
P
Economies of scale:
Ability of established firms
* To produce any given level of output
greater than a certain level Q* at
lower unit costs and
* To restrict potential entrants who are
not able to invest in that level of
production
D
LAC
Barriers to entry

ECW2731
Weeks 7 & 8
Price
Quantity
Q*
P*
advantages:
Variety of demand curves
and common LAC.
Some firms have advantage of
technology or specialisation and
are facing demand curves to the
right of the critical one.
D1
LAC
D2
D2
Barriers to entry

ECW2731
Weeks 7 & 8
Appear as the result of
• Ability to affect prices and
• Separation of ownership and managerial control
* Managers’ aim at stability and increase in salaries
*Stability may be achieved through the increase in the scale of operations
*Increase in sales (not in profit) affects manager’s remuneration
* Banks and retailers would prefer to deal with firms increasing the volume of sales
Non-profit-maximising competition.

ECW2731
Weeks 7 & 8
D
MR
AC
MC
Q
P, Cost
Profit
maximising
decision
Non-profit-maximising
competition.

ECW2731
Weeks 7 & 8
D
MR
Q
P, Cost
Profit
maximising
decision
Sales
maximising
decision
• Increasing sales, the firm is
moving to the right and
downward the demand curve
and, therefore, decreases
price,
• The limitation is AC curve.
Some profit should be earned
anyway
competition.

ECW2731
Weeks 7 & 8
Old sales maximising decision is a profit
maximising decision at a new level
of average cost
Old profit
maximising
decision
New profit
maximising
decision
D
MR
AC
MC
Q
P, Cost
competition.

ECW2731
Weeks 7 & 8
Seller concentration
refers to the degree to which production for a
particular market or or in a particular industry
is concentrated in the hand of few large firms
• number of firms in the market
• size distribution of firms in the market
Measurement of concentration

ECW2731
Weeks 7 & 8
The
Australian
Bureau of
Statistics
8140.0.55.001 Industry
Concentration Statistics

ECW2731
Weeks 7 & 8
C2542 - Paint Manufacturing in Australia
KEY COMPETITORS (www.ibisworld.com.au/static/iwabout/SamIndPart.asp)
MAJOR PLAYERS
Table: Market Share
Major Player Market Share Range
Orica Limited 22.00% - 25.00% (2004)
Wattyl Limited 17.00% - 19.00% (2004)
Barloworld Australia Pty Limited 9.00% - 11.00% (2004)
Akzo Nobel Industries Limited 7.00% - 9.00% (2003)

ECW2731
Weeks 7 & 8
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    
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Measurement of
concentration

ECW2731
Weeks 7 & 8Census Measures of Market Concentration
• Concentration Ratios
– Group market share data are called concentration ratios.
– CRi = ∑ Xi, where Xi is market share of the ith leading firm.
– CRi = 100 for monopoly.
– CRi ≈ 0 for a perfectly competitive industry.
• Herfindahl-Hirschmann Index
– Calculated in percentage terms, the HHI is the sum of squared
market shares for all competitors.
– HHI = ∑ Xi2, where Xi2 is squared market share of the ith firm.
– HHI = 10,000 for monopoly.
– HHI ≈ 0 for a perfectly competitive industry.
• Limitations of Census Information
– Slow reports hinder usefulness.
– National statistics obscure local markets.

ECW2731
Weeks 7 & 8
N
Measurement of concentration
Diagrammatic approach
No of firms cumulated from the largest
Cumulative
%
of
output
100%
The curve of equal
distribution of shares
of the market among
firms
The curve of real (not
equal distribution
This distance measures
concentration

ECW2731
Weeks 7 & 8
Multinational companies. Vertical and horizontal coordination.
Diversification
Vertical coordination
Multinational company

ECW2731
Weeks 7 & 8
Invest in production
facilities to produce
a product D
A firm X
producing
a good A
Buys shares of
a firm Y producing
a good B
Invents a new
product C
Diversification

ECW2731
Weeks 7 & 8
A firm X
producing
a good A

ECW2731
Weeks 7 & 8
facilities or buys shares
of or coordinate activities
with a firm producing an
input D
A firm X
producing
a good A

ECW2731
Weeks 7 & 8
input D
A firm X
producing
a good A
Invest in facilities or
buys shares of or
coordinate activities
with a firm providing
professional training
for employees

ECW2731
Weeks 7 & 8
input D
A firm X
producing
a good A
buys shares of or
for employees
of or coordinate
activities with a firm using
A as an input

ECW2731
Weeks 7 & 8
input D
A firm X
producing
a good A
buys shares of or
for employees
of or coordinate
activities with a firm using
A as an input
Invest in or buys shares
with a firm specialising in
the selling of product A

ECW2731
Weeks 7 & 8
A firm producing
a good A in a
home country
Establishes
branches in other
countries
Buys share of
analogous firms
in other countries
Undertake
vertical
coordination
measures abroad
Conduct
diversification
practices abroad
Multinational company

2731L78.ppt

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