A2 7b. Market Structures 2.pptx

Warm Up
How does PC differ from MC?
Which methods can MC firms use to engage in non-price competition?

Monopolistic Competition Assumptions:
This is similar to PC because of the large number of competing suppliers. However, there is a downward
sloping demand curve. PED is high as many substitutes exist
Again, firms can make Supernormal Profits in the SR, but, due to relatively free entry (and exit), these will be
competed away to Normal Profits in the LR.
Characteristics of Monopolistic Competition
1-Large Number of Buyers and sellers
2-Few Barriers to Entry/Exit so firms can easily enter and exit the
industry. However, branding can act as a limited entry barrier.
No sunk costs
3-Consumers face a wide choice of ‘differentiated goods’, and
each firm has, in controlling its own brand, a degree of market
power
4-Firms thus have influence over market price and are price
makers
5-Each firm is a profit maximiser (MC=MR)

Product Differentiation Strategies

Warm Up
1. Identify some characteristics of a MC market.
2. Identify some real world examples of MC markets and explain why they fit
this market structure.
3. Using a diagram (N.P.), explain why a MC firm is economically inefficient.

Monopolistic Competition – Short Run
Product differentiation is very important
in this market structure.
Developing this or even a brand image
can be expensive and must be seen as an
investment by the firm (fixed costs)
Effective branding makes substitutes less
attractive and reduces the PED of the
firms products.
This allows firms to make Economic
Profits in the SR
Economic
Profit

Monopolistic Competition: SR Equilibrium
OUTPUT
COST /
REVENUE

OUTPUT
COST /
REVENUE
MR1
D1 = AR1

OUTPUT
COST /
REVENUE
MR1
D1 = AR1
MC
ATC

OUTPUT
COST /
REVENUE
MR1
D1 = AR1
MC
ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚

OUTPUT
COST /
REVENUE
MR1
D1 = AR1
MC
ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚
𝑝𝑚

OUTPUT
COST /
REVENUE
MR1
D1 = AR1
MC
ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚
𝑝𝑚
𝐴𝑇𝐶𝑚

OUTPUT
COST /
REVENUE
MR1
D1 = AR1
MC
ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚
𝑝𝑚
𝐴𝑇𝐶𝑚
𝚷 > 𝟎

Monopolistic Competition: LR Equilibrium
OUTPUT
COST /
REVENUE
MC
ATC
D2 = AR2
D1 = AR1

OUTPUT
COST /
REVENUE
MC
ATC
D2 = AR2
MR2

OUTPUT
COST /
REVENUE
MC
ATC
D2 = AR2
MR2
𝑀𝐶𝑚 = 𝑀𝑅𝑚
𝑞𝑚

OUTPUT
COST /
REVENUE
MC
ATC
D2 = AR2
MR2
𝑝𝑚 = 𝐴𝑇𝐶𝑚
𝑞𝑚

OUTPUT
COST /
REVENUE
MC
ATC
D2 = AR2
MR2
𝑝𝑚 = 𝐴𝑇𝐶𝑚
NORMAL
PROFIT
𝑞𝑚

OUTPUT
COST /
REVENUE
MR1
D1 = AR1
MC ATC

OUTPUT
COST /
REVENUE
MR1
D1 = AR1
MC ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚

OUTPUT
COST /
REVENUE
MR1
D1 = AR1
MC ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚
𝑝𝑚

OUTPUT
COST /
REVENUE
MR1
D1 = AR1
MC ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚
𝑝𝑚
𝐴𝑇𝐶𝑚

OUTPUT
COST /
REVENUE
MR1
D1 = AR1
MC ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚
𝑝𝑚
𝐴𝑇𝐶𝑚
𝚷 < 𝟎

OUTPUT
COST /
REVENUE
D1 = AR1
MC ATC
D2 = AR2

OUTPUT
COST /
REVENUE
MR2
MC ATC
D2 = AR2

OUTPUT
COST /
REVENUE
MR2
MC ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚
D2 = AR2

OUTPUT
COST /
REVENUE
MR2
MC ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚
𝑝𝑚
= 𝐴𝑇𝐶𝑚
D2 = AR2

OUTPUT
COST /
REVENUE
MR2
MC ATC
𝑞𝑚
𝑀𝐶𝑚
= 𝑀𝑅𝑚
𝑝𝑚
= 𝐴𝑇𝐶𝑚
D2 = AR2
NORMAL
PROFIT

As more firms enter the market, the
demand curve moves to the left as
consumers choose the products offered
by new or alternative companies.
(demand for firms product falls)
The demand curve continues to move to
the left until it is tangential to the AC
curve.
At this point, the monopolistically
competitive firm is at its profit-
maximising level of output (MR = MC)
but is making normal profit (AR = AC)
Normal
Profit

Monopolistic Competition-LR
• In the short run and long run
the firm will profit maximise
where marginal cost equals
marginal revenue
• However, in the long run new
firms will be attracted into the
industry by the supernormal
profits. This will shift the
average revenue curve to the
left until eventually average
revenue is equal to average
cost - normal profit. The key point here is that in both the short run AND the
long run the firm is Economically INEFFICIENT!
It will operate at a point above its minimum average
total cost (AC ≠ MC) and excess capacity will exist
Price is usually above marginal cost
PROFITS ARE COMPETED AWAY AS
THE DEMAND CURVE SHIFTS LEFT !

Normal
Profit
• Freedom of entry sees Economic Profits competed away in the LR
• With suppliers using a combination of price and non-price tactics to increase Market
Power, Freedom of Entry means any success is short-lived in monopolistic competition

What is the outcome here?
The firm will leave the industry and use its resources in a more profitable
industry

MC
ATC
MR D
QM
PM
Price
0 Quantity
Diagram Exercise
Using diagrams, explain short run and long run equilibrium for firms in Monopolistic
Competition

Warm Up
Diagrams  Explain what happens when firms make supernormal profit in a PC
market.

Evaluation Practice
Create a table that lists the advantages and disadvantages of Monopolistic Competition.

Warm Up
1) Evaluate:
PC markets
MC markets
PC vs MC markets
2) Identify characteristics of Oligopoly.

Barriers to Entry Revisited
• The existence of Barriers To
Entry (BTE) and market
concentration/concentration
ratios separates Oligopolistic
(High BTE’s) and Monopolistic
Competition (Low BTE’s) from
Perfect Competition
• BTE’s are the range of obstacles that
deter or prevent new firms entering a
market to compete with existing firms
(affect profit levels)
• BTE’s give firms market power as they
can make decisions that will not be
challenged from outside (affect price
and output)
• The construction and maintenance of
these barriers is part of the firms’
behaviour and influences its plans

Oligopolies
• Oligopolistic industries are nothing if not diverse. Some sell identical products, others
differentiated products. Some have three or four firms of nearly equal size, others have
one large dominate firm (a clear industry leader) and a handful of smaller firms (that
follow the leader).
• However, through this diversity, all oligopolistic industries engage in similar types of
behavior. The most noted behavior tendencies are:
(1) interdependent decision making,
(2) relatively constant prices,
(3) competition in ways that do not involve prices,
(4) the legal merger of two or more firms, and (5) the illegal collusion among firms to
control price and production.

Interdependence
• Each firm in an oligopolistic industry keeps a close eye on the
activities of other firms in the industry. Because oligopolistic firms
engage in competition among the few, decisions made by one firm
invariably affect others.
• Competition among interdependent oligopoly firms is comparable to
a game or an athletic contest.
• One team's success depends not only on its own actions but the
actions of its competitors

Price rigidity in oligopoly markets
Oligopolistic industries tend to keep prices relatively constant, preferring to compete in ways that
do not involve changing the price. The prime reason for rigid prices rests with the interdependence
among oligopolistic firms.
• Because competing firms ARE NOT likely to match the price increases of an oligopolistic firm, the
firm is likely to loose customers and market share to the competition should it charge a higher
price. As such, it has little motive to increase its price.
• Because competing firms ARE likely to match the price decreases of an oligopolistic firm, the firm
is unlikely to gain customers and market share from the competition should it charge a lower
price. As such, it has little motive to decrease its price.

Oligopoly-characteristics
The three most important characteristics of oligopoly are:
(1) an industry dominated by a small number of large firms,
(2) firms sell either identical or differentiated products, and
(3) the industry has significant barriers to entry.
These three characteristics underlie common oligopolistic behavior, including
interdependent actions and decision making, the inclination to keep prices rigid, the
pursuit of non-price competition rather than price competition, the tendency for firms to
merge, and the incentive to form collusive arrangements.

Small number of large firms
• The most important characteristic of oligopoly is an industry dominated by a small
number of large firms, each of which is relatively large compared to the overall size
of the market. This characteristic gives each of the relatively large firms
substantial market control.
• While each firm does not have as much market control as monopoly, it definitely has
more than a monopolistically competitive firm.
• The total number of firms in an oligopolistic industry is not the key consideration. An
oligopoly firm actually can have a large number of firms, approaching that of any
monopolistically competitive industry. However, the distinguishing feature is that a
few of the firms are relatively large compared to the overall market. A given industry
with a thousand firms, for example, is considered oligopolistic if the top five firms
produce half of the industry's total output.

Homogenous(Identical) or differentiated
products
• Some oligopolistic industries produce identical products, like perfect
competition in this regard, while others produce differentiated products,
more like monopolistic competition
• In reality oligopolistic industries general come in two varieties:
a) Identical Product Oligopoly: This type of oligopoly tends to process raw
materials or produce intermediate goods that are used as inputs by other
industries. Notable examples are petroleum, steel, and aluminum.
b) Differentiate Product Oligopoly: This type of oligopoly tends to focus on
goods sold for personal consumption. The key is that people have
different wants and needs and thus enjoy variety. A few examples of
differentiated oligopolistic industries include automobiles, household
detergents, and computers.

Barriers to entry
Firms in an oligopolistic industry attain and retain market control
through barriers to entry. The most noted entry barriers are:
(1) exclusive resource ownership,
(2) patents and copyrights,
(3) other government restrictions, and
(4) high start-up cost.
• Barriers to entry are the key characteristic that separates oligopoly from
monopolistic competition on the continuum of market structures. With few
if any barriers to entry, firms can enter a monopolistically competitive
industry when existing firms receive economic profit. This diminishes the
market control of any given firm. However, with substantial entry barriers
found in oligopoly, firms cannot enter the industry as easily and thus
existing firms maintain greater market control.

Barriers to entry-example
• Consider the hypothetical oligopolistic Shady Valley athletic shoe market dominated by OmniRun,
Inc. and The Master Foot Company. Each of these firms has produced athletic shoes for several
years. They have well-known brand names, state-of-the-art factories that provide economies of
scale for large volumes of production, and a few patents on how their shoes are made.
• Any firm seeking to enter this market is faced with significant barriers:
i. First, a new firm must compete with the established Fleet Foot and OmniFast brand names. At
the very least, this requires a substantial amount of expensive upfront advertising and
promotion.
ii. Second, a new entry has to construct a new factory. With limited initial sales, this new firm in
the market will be unable to take full advantage of decreasing short-run average cost or long-
run economies of scale
iii. Third, any new firm has to devise its own production techniques to compete with the patented
techniques used by OmniRun and Master Foot.
• While a new firm could enter this oligopolistic market, such a task is significantly more difficult
than entering an industry with fewer barriers.

Industry concentration
• Concentration is a measure of how much market share is controlled by the largest
firms in the industry.
• Oligopoly is a market structure that contains a small number of relatively large
firms, meaning oligopoly markets tend to be concentrated.
• A small number of large firms account for a majority of total output.
Concentration unto itself is not necessarily bad, but it often leads to inefficient
behavior, such as collusion and non-price competition.
• In fact, oligopoly is the only one of the four market structures where
concentration is really an issue.
• Because monopoly is the only supplier in a market, concentration is not
particularly relevant. The monopoly IS the market. Because monopolistic
competition and perfect competition contain large numbers of small firms,
concentration is barely measurable.

Examples of oligopoly markets
Real world markets are heavily populated by oligopoly. About half of all output produced in the U.S. economy
each year is done so by oligopoly firms. Other industrialized nations can make a similar claim. Oligopoly
markets arise in different industries, ranging from manufacturing to retail trade to resource extraction to
financial services.
Automobiles
• At the top of the list is the market for cars, which has been one of the most important industries in this
country for decades. A handful of firms--especially General Motors, Ford, Chrysler, Honda, and Toyota--
account for over 90 percent of the cars, trucks, vans, and sport utility vehicles sold in the United States. The
need for large factories, a nation-wide network of dealerships, and brand name recognition create entry
barriers that limit production to a few large firms.
Petroleum
• An industry closely tied to the market for cars is the extraction and refinement of petroleum. A few
representatives in this market include , ConocoPhillips, Gulf, and Shell. While the petroleum industry
contains hundreds, if not thousands, of smaller firms, the biggest ones tend to dominate the market. In
addition, another major player on the international scene is the Organization of Petroleum Exporting
Countries (OPEC), which is an international cartel representing several petroleum-rich countries especially in
the Middle East. Ownership and control of petroleum resources is a prime factor in the creation of an
oligopolistic industry.

Examples of Oligopoly markets
Tires
• Another industry closely connected to the automobile industry is the manufacture of
tires. Every car needs tires. This industry is also dominated by a small number of familiar
firms as well, including Goodyear, Firestone, Goodrich, Uniroyal, and Michelin. The
number of firms in this industry is also limited by the need for large factories.
Computers
• An increasingly important market is that for personal computers. The manufacture of
computers tends to be dominated by a small number of firms, including Dell, Hewlett-
Packard, Gateway, Apple, and IBM. Although entry barriers are not very high, brand
name recognition and the need for manufacturing facilities tend to limit the entry of
other firms.

Examples of oligopoly markets
Banking
• A market that is becoming increasingly oligopolistic is banking. While the United States has a total
of approximately 20,000 banks, a small contingent of firms tends to dominate the national
market. Names include Citibank, Bank of America, Wells Fargo, Bank One, and MBNA. The key
entry barrier that limits the number of firms in the banking industry is government authorization.
Before a firm can provide banking services, it must obtain a government license.
Wireless Telephone
• Throughout much of the 1900s, the only company providing telephone services was AT&T.
Technological advances and regulatory changes enabled the development of an oligopolistic
market for wireless telephone services (cell phones). AT&T has been joined by a small number of
other companies, including Verizon, Cingular, Sprint, T-Mobile. The need for a nation-wide
network of relay towers makes this industry well suited for a small number of large companies.

Examples of oligopolistic markets
Television
• While television sets are filled with hundreds of television channels, only a handful of companies
dominate the market. The big players, including Disney (ABC, ESPN, Disney), Viacom (CBS, UPN,
MTV), General Electric (NBC, Bravo, CNBC), Time-Warner (HBO, WB, CNN, TBS), and News Corp.
(Fox, FX, Fox News), own and control many of the channels. (These companies also play major
roles in related markets--including motion pictures, cable systems, radio and television stations,
and newspapers.) Domination by a few firms arises due to the upfront costs of producing
programming and acquiring satellite relay access.
Airlines
• The airline industry has long been dominated by a small number of firms. Throughout the middle
part of the 1900s, seven firms dominated the U.S. market--American, United, TWA, PanAm,
Continental, Braniff, and Eastern. However, deregulation in the 1980s lead to decades of changes.
Some airlines folded. New airlines emerged. Even though changes continue, the industry remains
dominated by a small number of competitors--American, United, Southwest, Delta. Heavy
expenses needed to purchase planes, establish flight routes, and acquire terminal space tends to
limit the entry of new firms.

OLIGOPOLY
• Oligopoly is a market structure where total
output is concentrated in the hands of a few
firms.
• Can also be defined as competition among a
few.
• Other smaller firms may exist alongside the
dominant firms. So an industry with 100 firms
where three large ones control 80% of the
market (3:80) is still considered an oligopoly.
• ‘Concentration ratio’ a very useful measure of
market concentration to identify oligopoly
(distinguish from MC).
• An ‘effective oligopoly’ can exist in an
apparently competitive market if a handful of
firms ‘collude’ or form a ‘Cartel’ to dominate
the market (eg Airlines or OPEC)
• An extreme form of oligopoly is a duopoly,
where just two dominant firms exist in a market
• 1-Market dominated by a small
number of firms (High CR)
• 2-Decisions are interdependent
as they will elicit a response
from rivals.
• 3-High barriers to entry/exit
• 4-Products may be homogenous
or differentiated
• 5-Uncertainty/risk of price
competition/wars may lead to
price rigidity
General Characteristics

BEIJING - Booking a taxi, ordering food, reading the news, watching movies and playing games - the
seemingly infinite number of apps on the Chinese market, gives the illusion of an open, competitive
market.
However, the plethora of apps notwithstanding, experts warn that the majority of apps on the market
are BAT- (Baidu, Alibaba and Tencent) run services.
According to Analysis International, all but one of September's ten most downloaded apps were BAT
products. In fact, Sogou Typewriting, the only exception, later received investment from Tencent.
Industry insiders said that BAT's rapid mergers and acquisitions have left startups with little room to
compete.
Concerns have been raised over whether innovation and user's rights may both fall by the wayside as
the Internet behemoths become too big to fail.
Is China in an age of Internet oligopoly?
According to the report, how did this oligopoly form?
What are the potential dangers of this emerging oligopoly?

Current Examples of Oligopolies in US Markets
National mass media and news outlets are a prime example of an
oligopoly, with 90% of U.S. media outlets owned by six corporations: Walt
Disney (DIS), Time Warner (TWX), CBS Corporation (CBS), Viacom (VIAB),
NBC Universal, and Rupert Murdoch’s News Corporation (NWSA).
Operating systems for smartphones and computers provide excellent
examples of oligopolies. Apple iOS and Google Android dominate
smartphone operating systems, while computer operating systems are
overshadowed by Apple and Windows. (duopoly?)
The auto industry is another example of an oligopoly, with the leading auto
manufacturers in the United States being Ford (F), GMC, and Chrysler.
While there are smaller cell phone service providers, the providers that
tend to dominate the industry are Verizon (VZ), Sprint (S), AT&T (T), and T-
Mobile (TMUS).
The music entertainment industry is dominated by Universal Music Group,
Sony BMG, Warner and EMI Group.
Also:
• Airlines
• Oil and Gas
• Pharmaceuticals
• Aluminum and Steel

OLIGOPOLY
• Realistic model, but sees firms as
either:
• a) competing aggressively
• b) colluding and cooperating
• Price making powers can lead to
‘price wars’ (e.g. over market
share)
• Because of uncertainty of
outcome of the above, firms
may prefer to go for non-price
competition
• There is no single theory of
price and output under
oligopoly.
• If a price war breaks out,
oligopolists may produce and
price much as a highly
competitive industry would; at
other times they act like a pure
monopoly.
• Because of the fear
factor/uncertainty, we tend to
see stable prices in oligopolies.

Oligopoly and Competition: Fear of Price Wars
Price war is commercial competition characterized by the repeated
cutting of prices below those of competitors.
One firm will lower its price, then others will lower their prices to match.
If one of them reduces their price again, a new round of reductions starts.
In the short run, price wars are good for buyers, who can take advantage
of lower prices. Often they are not good for the companies involved
because the lower prices reduce profit margins and can threaten their
survival.
In the medium to long run, price wars can be good for the dominant
(larger) firms in the industry. Typically, the smaller firms cannot compete
and must close.
The remaining firms absorb the market share of those that have closed.
The real losers, then, are the smaller firms and their investors.
In the long run, the consumer may lose too. With fewer firms in the
industry, prices tend to increase, sometimes higher than before the price
war started.

As a result, price is likely to remain stable at P
because:
a) The firm will reason that lowering price will
produce limited gains and might start a
price war.
b) Raising the price will result in a substantial
loss of market share.
The kinked demand curve theory also states
that the price may remain unchanged even if
costs rise.
To understand this we need to add the MR and
MC curves.

Explaining the Kinked Demand Curve
Firm A is originally operating at Q with a price of P. The firm is
considering its pricing strategy.
1) If it reduces its price, its rivals will do the same. It will gain
little market share (P1, Q2) and TR will fall. (EOIS)
So the firm is likely to perceive its demand curve (AR) as
relatively inelastic when decreasing price. This is shown by Di.
2) If it increases its price, rivals are unlikely to follow. If rivals
leave their prices unchanged, they will gain market share while
Firm A loses (P3, Q4). Again, TR will fall. (EOIS)
So the firm is likely to perceive its demand curve as relatively
elastic when increasing price. This is shown by Df.
3) Therefore, the overall demand curve the firm faces then is a
mixture of the two. As shown by the light blue curve with a
kink (bend) at point A. A price change in either direction is
undesirable and will lead to a fall in revenue and little or no
gain in market share.

Now adding the MR and MC
curves…
MR is below AR and falls at twice
the rate.
However, because of the kink, it is
not possible to draw a single
continuous MR curve.
So the MR curve has a
discontinuity (break) at output Q1.

The profit maximizing firm will always
produce at MC=MR.
So if the firms costs increase and cause
the MC curve to shift upward within
the discontinuity, the profit
maximizing output and price will not
change.
Only if the MC curve rises outside of
the discontinuity will the profit
maximizing output and price change.

Kinked Demand Model with MC and AC Curves

Evaluation of the Kinked Demand Curve Theory (AO4)
Useful for explaining price rigidity in oligopoly even with rising
costs. Good demonstration of interdependence.
It does not explain how the firm chooses its original price and
output level.
It assumes that firms operate based on price competition.
However, oligopolies tend to have heavy non-price competition.
The model assumes that firms will always react to changes in
price in the same way. There is a much wider range of possible
reactions available.(explained in the next slide)

Indeterminateness of Demand Curve:
In market structures other than oligopolistic, demand curve faced by a firm is determinate. The
interdependence of the oligopolists, however, makes it impossible to draw a demand curve for such
sellers except for the situations where the form of interdependence is well defined. In real business
operations, the demand curve remains indeterminate. Under oligopoly a firm can expect at least
three different reactions of the other sellers when it lowers its prices:
(I)It is possible that others maintain the prices they had before. In this case, an oligopolist can hope
that its demand would increase substantially as the prices are lowered,
(ii)When an oligopolist reduces his price, the other sellers also lower their prices by an equivalent
amount. In this situation although demand of the oligopolist making the first move will increase
as he lowers his price, the increase itself would be much smaller than in the first case.
(iii)When a firm reduces its price, the other sellers reduce their prices far more. Under the
circumstances the demand for the product of the oligopolistic firm which makes the first move
may decrease. Thus uncertainty under oligopoly is inevitable, and as a result, the demand curve
faced by each firm belonging to the group is necessarily indeterminate.

Price Rigidity  cannot use pricing policy as a competitive tool.
(Price War)
Therefore, 2 options:
Non-price competition (battle for market share)
Collusion (e.g. price fixing)
Implications of Kinked Demand Curve

Using a diagram, explain the concept of interdependence, price wars and price rigidity in oligopolistic
markets. [12]
Exam Practice
Can this firm maintain its current price and
output with rising marginal costs?
If there had been a price war and the price
stabilized at P2, what would be this firm’s
profit position?

Explain the way firms might behave in oligopolistic markets? (reasons)
•Price competition vs Non-price competition
•Cooperation vs Collusion
Warm Up

Non-price Competition
1-Advertising and promotions to attract customers in
new ways
2-Product Innovation-develop product: Apple -
iphone 4,5,6,etc
3-Brand Proliferation-market saturated and no gaps
for rivals
4-Market Segmentation-identified markets or niches
specially catered for
5-Process Innovation-cost cutting (thin crust)

Oligopoly-key concepts
Collusive Pricing Policy
1. Limit Pricing- firms deliberately
abandon profit maximising (to either
disguise the potential for abnormal
profits and/or to prevent new firms
from entering market
2. Price Leadership- biggest firm has
power to set ‘market price’ and other
firms follow the lead.
3. Price Fixing – Collusive oligopolies
agree on a ‘fixed’ (high) price to sell to
in the market rather than competing.
• Horizontal integration –where a firm
grows (its market share and market
power) by merger or takeover of
another similar company
• Cartels – a formal agreement to limit
competition and/or fix prices (and
output) eg OPEC, many airlines
• Collusion – explicit (cartels and formal
agreements) or tacit/implicit (no formal
agreement or just follow market leader)

Game theory
Key concepts
Players-could be consumers or producers.
Pay offs-gaining more utility for consumers or gaining more profit, market share, reducing the risk of a loss.
Strategies-predicting how consumers or other firms will react to decisions made by the firm.
Independence and uncertainty-game theory attempts to explain the behavior of interdependent firms
operating under conditions of uncertainty.
Strategic choices could included decisions on price and output such as whether to:
• Raise
• Lower
• Hold
Decisions on products, such as whether to:
• Keep existing products
• Develop new ones

Game theory
Key concepts
Decisions on promoting products such as whether to:
• Spend more on advertising
• Spend less
• Keep spending constant
Dominant strategy- a dominant strategy is the best outcome irrespective of what the other player chooses
Nash equilibrium-this is a solution to a game involving two or more players who want the best outcome for
themselves and must take the actions of others into account. When Nash equilibrium is reached, players
cannot improve their payoff by independently changing strategy

Oligopolists and Game Theory
• Oligopolists have a measure of
market power (with a
downward sloping demand
curve) and are thus price makers
• What they do not know is the
reaction of their competitors-
hence the preference for non-
price competition (branding,
customer service, locations etc)
• Pay-off matrix shows ‘rewards’ of
all outcomes.
• Game theory shows how rational-
decision makers using strategic
behaviour to maximise profits by
trying to guess the rival’s
behaviour may end up worse off
than if they were colluding

Nash equilibrium
a solution in which each player is assumed to know the equilibrium strategies of the
other player, and neither player has anything to gain by changing only their own
strategy.
Therefore, in the end both will confess. And receive 5 years in
prison.
What would happen if they were allowed to cooperate?
Game Theory: Prisoner’s Dilemma

Dominant
Strategy for A
Dominant
Strategy for
B
Nash Equilibrium
Neither firm has
incentive to change
strategy
This shows the benefits of cooperation/collusion
for oligopolistic firms.
Because of uncertainty and interdependence,
both firms will be forced into a suboptimal
outcome. (1.5 million each)
However, if both firms had decided to collude
they would have a much better pay off (2 million
each)
Therefore, their mutual self-interests are best
served by collusion.
Note: Even when firms collude players have an
incentive to betray the other (cheating)
For collusion to be effective there must be some
kind of deterrent for betrayal (i.e. punishment)
Works best with a dominant firm.
Competition or Collusion

Oligopoly
Oligopolistic Markets – the Game Theory Model
Because there are only a few large firms in oligopolistic markets, they often have a strong
incentive to cooperate, rather than compete, with one another on output and pricing decisions.
To understand why collusion is so attractive to oligopolistic firms, it is useful to think of competition between
them as a sort of game. For this, we will use a model of oligopoly behavior known as game theory.
Game Theory: The study of strategic decision making through the use of games
Consider the following example: Two firms, Swisscom and Sunrise, provide cell phone service to consumers
in Switzerland. These firms are trying to decide on the following:
• Whether to offer unlimited data to their customers (we will refer to this option as FREE), or
• Whether to charge customers based on data usage (we will refer to this option as PAY)
The profits of each firm depends not only on whether it offers free data, but also on
whether its competitor offers free data. In this regard, the firms are highly
interdependent on one another*
Game Theory

Oligopoly
The possible levels of profit Sunrise and SwissCom can earn depending on their decision
regarding data plans AND based on the competition’s decision can be plotted in a table called a
payoff matrix. Study the payoff matrix below:
Payoff Matrix
SwissCom
PAY FREE
Sunrise
PAY 10 , 10 5 , 20
FREE 20 , 5 7 , 7
In this “game”:
• Each firm can either choose “PAY” or
“FREE”
• The red number in each box is the possible
level of economic profit (in millions of
Swiss francs) enjoyed by Sunrise.
• The blue number is the possible profit
earned by Swisscom.
• Notice that each firm’s profit depends
largely on what the competition chooses
to do.
Determining the likely outcome of the game: Assume the firms do not collude. What will each
firm most likely do?
Game Theory

Oligopoly
To determine the most likely outcome in the game below, consider the possible payoffs the
firms face.
Payoff Matrix
SwissCom
PAY FREE
Sunrise
PAY 10 , 10 5 , 20
FREE 20 , 5 7 , 7
If Sunrise chooses “PAY”
• And SwissCom also chooses PAY,
Sunrise will earn profits of 10 million
• But if SwissCom chooses FREE,
Sunrise’s profits will fall to 5 million
If Sunrises chooses “FREE”
• And SwissCom chooses PAY, Sunrise
will earn profits of 20 million
• But if SwissCom also chooses FREE,
Sunrise’s profits will be 7 million.
Determining a dominant strategy: A strategy is dominant if it results in a higher payoff regardless of
what strategy the opponent chooses.
• In this game, both firms have a dominant strategy of choosing FREE.
• If SwissCom chooses PAY, Sunrise can do better by choosing FREE.
• If SwissCom chooses FREE, Sunrise can do better by choosing FREE.
Both firms can always do
better by choosing to offer
FREE data!
Game Theory

Oligopoly
The game on the previous slide is known as the Prisoner’s Dilemma. The firms in the game face a
dilemma because:
• Both firms want to maximize their own profits, but…
• The rational thing to do is to offer FREE data, because the potential profits are so great!
 20 million francs if the competitor chooses PAY, and
 7 million francs if the competitor chooses FREE,
 For a total possible payoff of 27 million francs
• The possible payoffs for offering PAY are lower
 10 million francs if the competitor offer PAY, and
 5 million francs if the competitor offers FREE,
 For a total possible payoff of 15 million francs
• When they act in their own rational self-interest, both firms end up earning less profits than
if they had instead acted irrationally.
• The dilemma is that, ultimately, the firms are likely to earn LESS total profits between them
by offering FREE data than they would have earned if they had only chosen PAY data. This is
because collusion was not possible.
BUT WHAT IF THE FIRMS WERE ABLE TO COLLUDE?
Game Theory

Oligopoly
Collusion in Oligopolistic Markets – the Game Theory Model
Game theory teaches us that in oligopolistic markets:
• Firms are highly interdependent on one another, and that…
• There is a good reason for firms to collude with one another, because
• Through collusion, firms can choose a strategy that maximizes total profits between them,
however…
• Such an outcome (both firms choosing PAY in our game) is highly unstable, because both
firms have a strong incentive to cheat.
Game theory in the real world: This model of oligopoly behavior can be used to analyze the
behavior of firms in oligopolistic markets on several levels, including:
• Whether to set a high price or a low price,
• Whether to advertise or not,
• Whether to offer free customer service
• Whether to offer a 1 year warranty or a three year warranty,
• Whether to open a store in a certain location or not… and so on…
In each of these scenarios, the decision one oligopolist makes will impact not only its own level of
profits, but also those of its close competitors.
Game Theory

Oligopoly
Collusion in Oligopolistic Markets – Forms of Collusion
The most globally recognizable and effective cartel is OPEC, the Organization of Petroleum Exporting
Countries . In 1973 members of OPEC reduced their production of oil. Because crude oil from the Middle
East was known to have few substitutes, OPEC member's profits skyrocketed. From 1973 to 1979, the
price of oil increased by $70 per barrel, an unprecedented number at the time. In the mid 1980s,
however, OPEC started to weaken. Discovery of new oil fields in Alaska and Canada introduced new
alternatives to Middle Eastern oil, causing OPEC's prices and profits to fall. Around the same time OPEC
members also started cheating to try to increase individual profits.
Collusion

Oligopoly
Collusion in Oligopolistic Markets – Forms of
Collusion
Examples of cartels: OPEC (Organization of Petroleum
Exporting Countries), International sugar producers,
international coffee growers, drug cartels of Latin America.
Collusion

Oligopoly
Collusion in oligopolistic markets can take several forms:
Open / Formal/Overt Collusion: The firms in a particular industry may form an official
organization through which price and output decisions are agreed upon. This is called a CARTEL.
• Cartels are illegal in most industries in most countries, due to their anti-competitive nature
• The firms in a cartel will choose an output and price that a monopolist would choose
• The price consumers pay will be higher, the output lower (consumer surplus lower)
• Cartels tend to stifle innovation among firms and reduce both productive and allocative efficiency.
• Due to the prisoner’s dilemma explained on previous slides (there is always an incentive to cheat in a
collusive oligopoly), cartel arrangements are often unstable and difficult to maintain. Once the majority
of firms have agreed to a high price and reduced output, each individual firm has a strong incentive to
increase its output to take advantage of the higher price in the market. If all firms do this, the market
price will fall and the cartel will fail
Collusion

Oligopoly
Collusion in oligopolistic markets can take several forms:
Tacit / Informal Collusion: Since formal collusion is illegal in many countries, oligopolistic firms have devised
way to collude informally. The most common form of tacit collusion is Price Leadership:
• Price leadership: This is when the biggest firm in an industry sets a price and the smaller firms follow suit.
If the price leader raises its price, the competitors will too. If it lowers price, smaller firms will follow.
• Usually a "dominant firm" (typically the largest in the industry) establish the price and smaller firms
follow.
• Prices tend to be "sticky" upwards, since firms are hesitant to raise prices and lose market share to rivals.
• However, prices are "slippery" downwards, which means if one firm lowers its prices, others will follow
suit so they don't lose all their business.
Price Wars: When tacit agreements break down, firms may engage in price wars, in which they continually
lower their prices and increase output in order to try and attract more customers than their rivals.
• This can cause sudden increases in output and decreases in price, temporarily approaching an efficient
level.
• Once firms realize low prices hurt everyone, price leadership is usually restored, and prices rise once
more.
Collusion

Oligopoly
Non-Collusive Oligopolies – the Kinked Demand Curve Model
What if collusion is not possible? Price and output decisions in oligopolies can be analyzed using
a more traditional model of firm behavior, the demand curve.
P
Q
D1
MR1
D2
MR2
Demand for Big Macs
$5
Q1
Consider the market for hamburgers: Assume there are
only two firms selling hamburgers, McDonald’s (the Big
Mac) and Burger King (the Whopper). What does demand
for McD’s Big Mac look like? The current price of both Big
Macs and Whoppers is $5. McD’s is considering changing its
price.
• If McD’s lowers its price, it should assume that BK will
also lower its price, because if they do not, they will lose
many consumers to McD’s.
• With this assumption, demand for Big Macs is likely
highly inelastic below $5. Very few new customers will
buy Big Macs, since the price of Whoppers will also fall.
• If McD’s raises its price, it should assume that BK will ignore the price increase, since they know lots of
Big Mac consumers will switch over to Whoppers.
• With this assumption, demand for Big macs is highly elastic above $5. Many Big Mac consumers will
switch to Whoppers, since the price of Whoppers will stay at $5 when McD’s raises its price
Kinked Demand
Curve

Oligopoly
Based on the analysis on the previous slide, we can conclude that the demand for Big Macs, as
seen by McDonald’s is actually a kinked demand curve.
P
Q
D
MR
Demand for Big Macs
$5
Q1
Demand is highly elastic above the current price:
• BK will ignore a price increase by McD’s
• Many consumers will switch to Whoppers
• A price increase would lead to a fall in McD’s total
revenues.
Demand is highly inelastic below the current price:
• BK will match price increases by McD’s
• Very few new consumers will buy Big Macs
• A price decrease would lead to a fall in McD’s total
revenues
The price in a non-collusive oligopolistic market tends to be very stable. Firms are unlikely to
raise or lower prices since in either case, total revenues will fall, possibly reducing profits.
Kinked Demand
Curve

Oligopoly
Even as a firm’s costs rise and fall, the firm is not likely to quickly change its level of output and
price in a non-collusive oligopoly. Observe the graph below:
P
Q
D
MR
Demand for Big Macs
$5
Q1
MC2
MC1
MC3
Assume due to rising beef prices, the marginal costs
of Big Macs has risen from MC1 to MC3
• Following its profit maximization rule of
producing where MC=MR, McD’s should not
change its price or quantity, even as the price of
beef rises.
• Only if marginal cost rose higher than MC3 would
McD’s have to raise its price and reduce its
output to maintain it profit maximizing level.
• Only if marginal cost fell lower than MC1 would
McD’s have to lower its price and increase its
output to maintain profit maximization.
Prices and output are highly inflexible in a non-
collusive oligopolistic market!
Kinked Demand
Curve

Oligopoly
Oligopoly Practice Question
Two Pizzerias, Luigi's and Mario's, provide all the pizza in the village of Wangi. They must order their menus from the printing
company at the beginning of the year and cannot alter the prices on their menus during that year. The prices on the menus are
revealed to the public and to the competition only after both companies have received the printed menus from the printer and put
them up in the window. Each pizzeria must choose between a high price and a low price for its "supremo-premium pie", the deluxe
pizza that the people of Wangi are most eagerly anticipating.
The payoff matrix showing the profits that the two firms will experience appears below, with the first entry in each cell indicating
Luigi's weekly profit and the second entry in each cell indicating Mario's weekly profit.
1. In which market structure do these firms
operate? Explain.
2. If Mario's choses a low price, which price is
better for Luigi's
3. Identify the dominant strategy for Mario's
4. Is choosing a low price a dominant strategy for
Luigi's? Explain.
5. If both firms know all the information in the
payoff matrix but do not cooperate, what will
be Mario's daily profit?
$1,000, $700 $700, $600
$750, $950 $900, $800
high price low price
low
price
high
price
Mario's Pizzeria
Luigi's
Pizzeria
Oligopoly
Practice

Research task
• From the internet, find 5 examples of firms that have been fined by
competition authorities in the world for collusion/price fixing

Cooperation v Collusion amongst Oligopolists
• The alternative to competition is
cooperation.
• Cooperation involving R&D and
joint ventures involving
standards, particularly with new
technology, is seen as positive
and legal
• However, cooperation can
also be seen as anti-
competitive (and often
illegal via collusion and
cartels and ‘price fixing and
price leadership’)
• This is clearly seen
negatively

Cooperation v Collusion amongst Oligopolists
• Price agreements to get Monopoly
power and supernormal profits are
both anti-competitive and illegal
• Firms often collude and agree to have
‘unwritten agreements’ (tacit-no hard
evidence) but this is also illegal
• More difficult to judge is unagreed ‘tacit
collusion’
• Think of a small local store that could
‘undercut’ a big supermarket on the price
of a good
• The fear is the supermarket will retaliate
and could drive the small shop out of
business. So it keeps prices high.
• For this reason, many firms refrain from
price competition as effectively as if they
had agreed to collude

Review
Define and explain the following terms to your partner:
1. Collusion
2. Explicit Collusion
3. Tacit Collusion
4. Cartel
5. Interdependence
6. Price Leadership
7. Price Fixing
8. Limit Pricing
Research task: what are some conditions that make it easier for firms to collude in oligopolistic
markets?

Collusion works best when:
1. Small number of participants (less
chance of one breaking agreement
2. Trust exists
3. Similar cost structures exist
4. Clear (market) leader exists
5. Agreement is enforceable with
punishments
6. Little danger of new entrants
7. Stable market conditions exist
8. Govt is either disinterested in
market or competition laws (anti-
trust) are weak

Sherman Antitrust Act (1890) – United States
The law attempts to prevent the artificial raising of prices by
restriction of output or through price fixing.
Administered by The Federal Trade Commission and the U.S.
Department of Justice
Notable Cases
United States v. AT&T Co., which was settled in 1982 and
resulted in the breakup of the company.
United States v. Microsoft Corp was settled in 2001 without the
breakup of the company.
Competition Act (1998) –UK
Prohibits price fixing, explicit collusion and the
emergence of cartels.
Supervises the mergers and acquisitions of large
corporations, including some joint ventures.
Administered by The Competition and Markets
Authority (CMA)
Government Laws and Intervention against Unfair Competition
Anti-trust Law- to enforce fair competition in the marketplace

Warm Up
1. Explain why collusive oligopolies might be harmful for competition and consumer
welfare.
2. Evaluate the pros and cons of oligopoly.
3. How would monopoly be different from oligopoly markets?

C
Oligopolies and Supernormal Profit
Supernormal Profits can be maintained in
the long run.
This is true for both collusive and individual
oligopoly firms.
Reasons:
1) Ability to set high prices (or low output)
allows Oligopolies to earn profit and extract
consumer surplus.
2) Existing high entry barriers and ability to
construct barriers to keep out New Entrants
allows long run SNP.

Equilibrium Model for a Cartel
Similar to short run equilibrium in
monopolistic competition but
Demand curve (AR Curve) is more
inelastic.
Almost exactly the same as model for
a pure monopoly since a Cartel
behaves in the same way.

Importance
Oligopolies are significant because they generate a considerable
share of most countries’ national income, and they dominate
many sectors within the national economy. (automobiles,
entertainment, banking, supermarkets, airlines, etc.)
Disadvantages of Oligopoly
However, oligopolies can be criticised for several reasons:
1. High concentration reduces consumer choice.
2. Collusive behaviour reduces competition and can lead to
higher prices and reduced output.
3. Firms can be prevented from entering a market because of
deliberate barriers to entry.
4. There is a potential loss of economic welfare.
5. Oligopolies tend to be both allocatively and productively
inefficient.
At profit maximising equilibrium, P, price is above MC, and
output, Q, is less than the productively efficient output, Q1, at
point A.
Evaluation of Oligopolies

The Advantages of Oligopolies
Oligopolies may provide the following benefits:
1. Oligopolies may adopt a highly competitive strategy, in
which case they can generate similar benefits to more
competitive market structures, such as lower prices.
2. Oligopolists may be dynamically efficient in terms of
innovation and new product and process development.
The super-normal profits they earn may be used to
innovate, in which case the consumer may gain.
3. Price rigidity may bring advantages to consumers and
the macro-economy because it helps consumers plan
ahead and stabilises their expenditure, which may help
stabilise the economy in general.
Evaluation of Oligopolies

What are the characteristics of this market structure?
How does it compare with other market structures?
What are the benefits of monopolies?
What are the dangers of monopolies?

Main Assumptions
• A single (dominant) seller in the
industry
• No close substitutes for good
• High barriers to entry
• The Monopolist is a price maker
(high market power)
• Potential for abnormal profit in
both the short run and long run
A Pure Monopoly is where a single firm controls the
entire output of the industry.
It is on the opposite end of the Market Structure
Spectrum from perfect competition.
Monopoly

• Technical Definition: just one firm in an industry
• Legal Definition (UK) where firm has more than 25% of
market share -if market share is 40%+ is seen as dominant
• A pure monopolist in an industry is a single seller. It is
rare for a firm to have a pure monopoly – except when
the industry is state-owned and has a legally protected
monopoly
• Example - The Royal Mail used to have a statutory
monopoly on delivering household mail. This is changing
fast as the industry has seen fresh competition. The Royal
Mail was part-privatised in 2013.
• A working monopoly: A working monopoly is any firm
with greater than 25% of the industries' total sales. In
practice, there are many markets where businesses enjoy
a degree of monopoly power even if they do not have a
25% market share.
• A dominant firm is a firm that has at least forty per cent
of their given market
Monopoly

Economic
Profit
Total Costs
A Monopolist faces a downward-sloping
Demand curve and can decide on price to
charge or quantity to supply (but not both)
The firm is a price maker but it cannot
charge a price that the consumers will not
bear.
A monopolist has market power which is
the power to raise price without fear of
losing supernormal profits to new
entrants to a market
Note-this is both the SR and the
LR position!

Economic
Profit
Total
Costs
Efficiency: Monopoly vs. Perfect Competition

“Oligopolistic firms are collusive by nature and harmful to competition and consumer welfare.”
To what extent to do you agree with this statement. [13]
Exam Practice#2

Explain why Monopolies are generally considered harmful. Is this always true?
Compare economic efficiency in PC and Monopolistic markets. (15 minutes)
2-3 paragraphs
1 paragraph  PC
2 paragraph  Monopoly
3 Paragraph  Compare and conclude
Warm Up

Exam Practice
1. Using diagrams, compare the efficiency of firms in PC and Monopolistic markets.
2. Write a paragraph evaluating oligopoly markets.

1) Explain why Monopolies are generally considered harmful.
Is this always true?
Warm Up

PC versus Monopoly
• 1-Monopoly has Higher Prices
• 2-Monopoly has Lower
Quantities
• 3-Monopoly SR/LR Abnormal
Profits
• 4-PC is productively efficient-
AC=MC
• 5-PC is allocatively efficient-
P=MC
• 6-DWL exists
• The case against Monopoly centres on higher prices,
less output and the ‘capture’ of large amounts of
consumer surplus, which is turned into producer
surplus ,and with an area of ‘Dead Weight Loss’
(DWL) resulting too
• Deadweight Loss  the costs to society created by
market inefficiency.
• DWL can be applied to any deficiency caused by an
inefficient allocation of resources and it occurs when
a market is not in equilibrium
• The high prices and lower quality and quantities
associated with monopoly is called X-inefficiency
X-INEFFICIENCY- WHERE LACK OF COMPETITION SEES
HIGHER COSTS (AND OFTEN POOR QUALITY/LACK OF
INNOVATION) PLUS LESS SUPPLY AND IDENTIFABLE
WELFARE LOSS
Summary

Deadweight Loss is the welfare loss due to the fact that desirable
consumption and production levels are not taking place.

Natural Monopoly
A natural monopoly occurs when the most efficient number of firms
in the industry is one.
A natural monopoly will typically have very high fixed costs meaning
that it is impractical to have more than one firm producing the good.
Examples of natural monopolies are utilities like tap water.
It makes sense to have just one company providing a network of
water pipes and sewers because there are very high capital costs
involved in setting up a national network of pipes and sewage
systems.
To have two or more companies offering water would not be
efficient as the average cost would be very high compared to just
one firm and one network.
There would also be the inconvenience of having two firms dig
up the road to lay a duplicate set of water pipes.
THEREFORE, with Natural Monopoly competition is
undesirable.

Explaining Natural Monopoly:
1. It is an industry where the long run
average cost curve falls continuously as
output expands.
2. It occurs when one large business can
supply the entire market at a lower price
than two or more smaller ones.
3. In the industry the minimum efficient scale
is a very large level of output and there is
room for only one firm to fully exploit all of
the available internal economies of scale.
4. If there were several smaller firms sharing
the market the price would be high and
output low. This is undesirable for
industries producing necessities
5. Therefore, there cannot be more than one
efficient provider of a good. In this
situation, competition might actually
increase costs and prices.
Natural Monopoly

Natural Monopolies and Public ownership
1. Falling LRAC shows continuing economies of
scale.
2. A profit maximizing monopoly would set
price at P and output at Q, earning
abnormal profits.
3. If it behaved like an efficient competitive
firm, price would be at P1 and output Q1.
(Allocative Efficiency)
4. However this would result in economic loss.
5. AE would only be achieved if the
government provided subsidies or the
service/good was provided by the public
sector.
6. Therefore NMs are often used to justify
public ownership
Long run equilibrium of Natural Monopoly

Natural Monopoly, Efficiency, And Government
Intervention

Warm Up
1.What are key characteristics of a natural monopoly?
2.Explain why natural monopolies are usually under
government control.

Monopoly - Price Discrimination
Price discrimination happens when a firm charges a different price to
different groups of consumers for an identical good or service, for reasons
not associated with costs of supply.

1) Differences in price elasticity of demand:
There must be a different price elasticity of
demand for each group of consumers.
The firm is then able to charge a higher price to
the group with a more price inelastic demand and
a lower price to the group with a more elastic
demand.
2) Barriers to prevent consumers switching from
one supplier to another:
The firm must be able to prevent "consumer
switching" – i.e. consumers who have purchased
a product at a lower price are able to re-sell it to
those consumers who would have otherwise paid
the expensive price.
(Market Seepage)
Firm must be a Price Maker

Degrees of PD
1st Degree PD  charging each consumer the
maximum they are willing to pay.
e.g. Scalper  Selling spare tickets for sold-out
sporting events and music concerts.
Can possibly be used to eliminate the entire
consumer surplus
2nd Degree PD  charging different prices for
successive units of consumption. (quantity)
e.g. Electricity companies, bulk buying
3rd Degree PD  charging different consumers
segments different prices for the same product
(elasticity)
e.g. taxi fares, cinemas, hairdressers
• If different groups are charged different prices
because the cost of production differs-then, it
is not price discrimination.
• Spreading out demand may help improve
efficiency, filling up ‘off-peak’ services (less
wastage, etc.)
• Price discrimination may allow
1)producer to cover costs on less popular
sections of a network (e.g. rural routes for
buses -> cross-subsidization
2)social objectives represented by discounts
(children/ pensioners/disabled)
3)‘loyalty’ rewards for repeat customers
Is Price Discrimination acceptable?

1st Degree PD  charging each consumer the
maximum they are willing to pay.
e.g. Scalper  Selling spare tickets for sold-out
sporting events and music concerts.
Can possibly be used to eliminate the entire
consumer surplus
2nd Degree PD  charging different prices for
successive units of consumption. (quantity)
e.g. Electricity companies, bulk buying
3rd Degree PD  charging different consumers
segments different prices for the same product
(elasticity)
e.g. taxi fares, cinemas, hairdressers

1 2 4
3
S
AR
250
200
150
100
Price of Tickets to Man United Game
£
The supplier separates the market into each individual
consumer and charges them the maximum price they
are willing and able to pay.
If successful, the supplier can extract the entire
consumer surplus that lies underneath the demand
curve and turn it into extra revenue or producer
surplus.
If all 4 tickets are sold at market price, TR=400.
However, if sold at maximum possible price TR=700.
In reality, this is hard to achieve unless a business has
full information on every consumer's individual
preferences and willingness to pay.
Market Research = $$$
1st Degree PD

AR
P1
P2
100 250
2nd Degree PD
This involves firms charging different prices for different
quantities of consumption.
Often used to unload excess inventories/spare capacity
A higher price is charged for the first units followed by a
lower price as additional units are consumed.

For electricity, consumers get charged
different tariffs depending on the quantity
consumed.
Classified into amount of electricity used.
‘Very small” consumers get charged highest
rate.
As quantity increases, different categories are
charged lower rates.
Electricity in the UK

The firm is able to segment its customers into
two or more separate markets, each market
defined by unique demand characteristics.
(age, income, occupation, gender)
Some of these customers might be less price
sensitive (price inelastic) relative to other
markets where quantity demanded is more
sensitive to price changes (price elastic).
This type of discrimination can be seen in the
movie theater business. Student and senior
discounts are given because these groups of
consumers have more elastic price elasticity of
demand than adult customers.
Other examples: domestic markets vs foreign
markets; airlines with last minute travelers
Note: This can also expand the market. Some
consumers previously excluded due to high
price now can afford purchase.
3rd Degree PD
MC
Cinema Tickets

Price Discrimination Charging customers different prices for the same good or service (at same cost)
Product Differentiation gives a supplier greater control over price and the potential to charge consumers a
premium price arising from differences in the quality or performance of a product
What is the difference between price discrimination and product differentiation?

Monopolies: Evaluation(AO4)
Lesson objective
• Evaluate the impact of monopolies on society
• Compare and contrast perfectly competitive markets with
monopolies(extension objective)

Starter activity
• On the mini whiteboards provided, scribble down what you know
about monopolies

Research task
• As a group, use the internet to find out the market shares of the
following companies
1. Google
2. Meituan
3. Intel
4. Facebook
5. Weibo
6. Alibaba
7. Tencent
8. Baidu
• Classify them as either working monopolies, dominant monopolies or
‘almost’ pure monopolies(80% and above)

Evaluation of monopolies(AO4)
Problems of monopolies
• Higher prices. Firms with monopoly power can set higher prices (Pm) than in a competitive
market (Pc).
• Allocative inefficiency. A monopoly is allocatively inefficient because in monopoly (at Qm) the
price is greater than MC. (P > MC). In a competitive market, the price would be lower and more
consumers would benefit from buying the good (this is a net loss of producer and consumer
surplus).
• Productive inefficiency A monopoly is productively inefficient because the output does not occur
at the lowest point on the AC curve.
• X – Inefficiency. – It is argued that a monopoly has less incentive to cut costs because it doesn’t
face competition from other firms. Therefore the AC curve is higher than it should be.
• Supernormal Profit. A monopolist makes Supernormal Profit leading to an unequal distribution of
income in society(equity issue)
Take notes please

Evaluation of monopolies(AO4)
Problems of monopolies
• Higher prices to suppliers – A monopoly may use its market power (monopsony power)
and pay lower prices to its suppliers. E.g. supermarkets have been criticised for paying
low prices to farmers. This is because farmers have little alternative but to supply
supermarkets who have dominant buying power. In this case the monopolist is also a
monopsonist.
• Diseconomies of scale – It is possible that if a monopoly gets too big it may
experience dis-economies of scale– higher average costs because it gets too big and
difficult to coordinate.
• Lack of incentives. A monopoly faces a lack of competition, and therefore, it may have
less incentive to work at product innovation and develop better products.
• Lack of choice. Consumers in a monopoly market face a lack of choice. In some markets
– clothing, choice is as important as price

Evaluation(AO4)
Advantages of monopolies
• Research and development. Monopolies can make supernormal profit, which can be used to fund
high-cost capital investment spending. Successful research can be used for improved products
and lower costs in the long term.
• Economies of scale Increased output will lead to a decrease in average costs of production. These
can be passed on to consumers in the form of lower prices
• International competitiveness. A domestic firm may have monopoly power in the domestic
country but face effective competition in global markets. E.g. British Steel has a domestic
monopoly but faces competition globally
• Monopolies can be successful firms. A firm may become a monopoly through being efficient and
dynamic
• Subsidise loss-making services. Another potential advantage of a monopoly is that they can use
their supernormal profit to subsidise socially useful but loss-making services.

Evaluation(AO4)
Advantages of monopolies
• Subsidise loss-making services. Another potential advantage of a monopoly is that they can use
their supernormal profit to subsidise socially useful but loss-making services.
• Avoid the duplication of services. In some areas, the most efficient number of firms is one. For
example, if a city deregulates its bus travel, then rival bus companies may compete for profitable
peak-hour services. This may lead to increased congestion as several buses turn up at once. It is
more efficient to have a monopoly and avoid this inefficient duplication of services.

Conclusion/judgement:AO4
• It depends on the industry in question. For example, a monopoly is
needed in a natural monopoly like tap water. However, for
restaurants, there are no significant economies of scale and it is
important to have a choice. Therefore monopoly would be very
inappropriate for restaurants.
• Some industries need a lot of research and development (e.g.
building new aeroplanes, research drugs). Therefore, a monopoly may
be needed in this industry.
• A government may be able to regulate monopolies to gain benefits of
economies of scale, without the disadvantages of higher prices.

Exit slips
• On the piece of paper given, write down what you understood today
and what you would want further explanations on.

Perfect competition vs monopoly
Output and Price:
• Under perfect competition price is equal to marginal cost at the equilibrium output. While under monopoly,
the price is greater than average cost.(diagram)
Equilibrium
• Under perfect competition equilibrium is possible only when MR = MC and MC cuts the MR curve from
below. But under simple monopoly, equilibrium can be realized whether marginal cost is rising, constant or
falling.(diagram)
Entry:
• Under perfect competition, there exist no restrictions on the entry or exit of firms into the industry.
Under simple monopoly, there are strong barriers on the entry and exit of firms.
Discrimination:
• Under simple monopoly, a monopolist can charge different prices from the different groups of buyers.
But, in the perfectly competitive market, it is absent by definition.

Profits:
• The difference between price and marginal cost under monopoly results in super-normal profits to the
monopolist. Under perfect competition, a firm in the long run enjoys only normal profits.(diagram)
Supply Curve of Firm:
• Under perfect competition, supply curve can be known. It is so because all firms can sell desired quantity at
the prevailing price. Moreover, there is no price discrimination. Under monopoly, supply curve cannot be
known. MC curve is not the supply curve of the monopolist
Slope of Demand Curve:
• Under perfect competition, demand curve is perfectly elastic. It is due to the existence of large number of
firms. Price of the product is determined by the industry and each firm has to accept that price. On the other
hand, under monopoly, average revenue curve slopes downward. AR and MR curves are separate from each
other. Price is determined by the monopolist. It has been shown in Figure 10.

Comparison of Price:
• Monopoly price is higher than perfect competition price. In the long run, under perfect competition, price is
equal to average cost. In monopoly, price is higher and greater than AC.
Comparison of Output:
• Perfect competition output is higher than monopoly price. Under perfect competition the firm is in
equilibrium at the point where AR = MR = AC = MC are equal. On the other hand monopoly firm is in
equilibrium at point M where MC=MR. The equilibrium output is ON. The monopoly output is lower than
perfectly competitive firm output.

Deadweight Loss is the welfare loss due to the fact that desirable
consumption and production levels are not taking place.
Efficiency comparisons between PC
And monopoly

Review:
What are the potential negative effects of
monopoly?
1. High price, low output
2. Abnormal Profits in LR
3. Economically Inefficient
4. Extracts consumer surplus and creates DWL
5. X-inefficiency
6. Intentional Entry Barriers

The Case for Monopolies
• 1-A monopolist cannot always make
abnormal profits. For example, a ‘natural
monopoly’, where 1 big firm can best
exploit EOS and having competing firms
makes no economic sense-networks often
NM’s
• 2-PC does not have LR Abnormal Profits,
the monopolist can plan investment with
guaranteed profits (adding to job security
for workers too)
• 3-Investment could go into ‘process
innovation’ lowering future costs
(Dynamic Efficiency)
• 4-In addition, it could finance ‘product
innovation’ adding to future consumer
welfare and widening choice
• 5-If most of the benefits of Economies
of Scale are actually passed on to the
consumers it could be argued that they
have gained from the existence of
abnormal profits

Market Structure Models: Conclusions
• The way a firm conducts business
depends upon 1) its objectives 2) the
market type it is in
• Price competition is paramount in PC,
in monopolistic competition and
oligopoly non-price competition
prevails
• Monopolies alone have full control
over prices
• PC is an ideal, but is somewhat
unrealistic, and all other market
structures fail to match its
performance
• All models come with the assumption of
‘profit maximisation’-this is particularly
unrepresentative of oligopoly
• The alternative motives examined in
‘behavioural theory’ (next) make it difficult
in reality to predict firms’ conduct in terms
of price and output-
• However, the models do give us a (flawed)
framework to examine and judge them

A2 7b. Market Structures 2.pptx

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