Level 5 Economics: Theory of the Firm [3]

Economic Principles Economic Environment

• Imperfect Competition

Level 5 Economics: Theory of the Firm [3]Learning Outcome Three

Theory of the Firm:3. Imperfect Competition

Tiwai Point Aluminium Smelter – Meridian's biggest customer

Wikimedia Commons

• barriers to entry into a market give existing suppliers market power– high capital costs / economies of scale– technological expertise

• registration systems / licensing / examinations

– patents / copyrights: "Intellectual Property Rights"• incl. trademarks: names and symbols (silver fern?)

– franchising / dealerships• parallel importing – dealer networks bypassed

– excessive government regulations ("red tape")– use of market power

• predatory pricing, control of inputs [examples?]

Barriers to Industry Entry limit Competition

S&R, S ch.6

diamonds, pounamu (NZ jade), local landline

ExerciseForm groups of 2 or 3.

Imagine you plan to start a new business.

Think of 2 industries inNew Zealand or in your home country

in which it would be extremely difficult for your new firm to enter the market.

Are some markets within that industry easier for a new firm to enter than others?

Efficient and Competitive Markets• Efficient Market for a commodity

– Price = Marginal Benefit = Marginal Cost[accounting for benefits to consumers and other parties][accounting for costs to producers and other parties]

• Perfectly Competitive Market– is efficient, without government intervention

• there are no "other parties"; only consumers, producers

– also Price = Minimum Average Cost

• Imperfectly Competitive Market– without government intervention, is not efficient

Monopoly• market with a single seller – a price-maker

– absence of competitors gives monopoly firms market power

• the most imperfect form of competition– NZ examples: NZ Bus, Auckland Airport (AIA), Vector

• competitive forces arise from substitutes– not all substitutes are obvious; eg home renovation

may be a substitute for overseas holidays• labour monopolies: unions and societies• Natural Monopoly

– technical efficiencies maximised if just one firm– large economies of scale exist Mankiw fig 1

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Advertisement from Auckland City Harbour News 25 August 2004

natural monopoly

Note KR: "Average Total Cost" here means what we call "Long-Run Average Cost" (LAC)

from Mankiw, Principles of Economics (4e), p.315

Revenue curves for perfect competition and monopoly• for perfect competition marginal revenue is

constant because S&R, S fig 6.2 (reminder)

– each firm is too small to influence the market supply curve

– hence the perfectly competitive firm cannot, on its own, influence the equilibrium market price

• a monopolist's marginal revenue curve is downward sloping S&R, S fig 6.3

– a monopolist's output is also the market's output an increase in a monopolist's supply reduces

the market price Impact on price: competition and monopoly compared.

Demand Curves Faced by Firms with Different Initial Market Shares

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$6.00

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output (Q) of individual firm

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0.1% market share 1% market share 5% market share

20% market share 50% market share 100% market share

Market Demand Curve

Average Revenue Curves, firms in industries with different levels of competition

20% increase in firm’s output; what happens to price?

Duopoly

Oligopoly

Monopoly

Equilibrium of the Firm; Imperfect Competition

• applying the MC=MR rule to establish Qe

• Profit () equals S&R, S fig 7.10

total revenue (TR) minus total cost (TC) = Q.AR–Q.AC = Q(AR–AC) = Q(P–AC) ∵ AR=P always

• firms maximise profit when S&R, S fig 7.11

marginal revenue (MR) equals marginal cost (MC)– under imperfect competition, MR < price

AR and MR slope down to the right

• firm's equilibrium, Imperfect Competition– above-normal profits apply and persist S&R, S fig 7.12a

Imperfect competition esp. monopoly.

= Price for a given

Q

fig 4 Mankiw

(new fig 7.12a)

Fig 7.12a

Multichoice Monopoly Exercise (ca)

Monopolistic Competition S&R, S end of ch.7

• industry includes small firms– commonly includes larger firms as well

• eg restaurants and fast food (McDonalds)

• product differentiation / variation S&R fig 7.18, S 7.15

– eg Nike, Levis etc• market leaders through successful branding

– marketing strategy designed to raise demand for brand and thereby to avoid price-cutting• successful brand variant enjoys less elastic demand

– differentiation can be achieved also bylevels of personal service, reputation etc.

• most well-known firms are monopolistic competitors

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Average Revenues of Undifferentiated Competitive Firms

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$3.00

$5.00

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output (Q) of individual firm

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Monopolistic Competition;

Average Revenues for successful

individual brands are like this.

Oligopoly / Duopoly S&R, S end of ch.7

• few sellers / two sellers [large size firms]– individual firms' supply each affect price

• examples» .

• high barriers to market entry lead to oligopoly• oligopolist firms compete for market share

– each rival firm happy to supply more (as economies of scale are common), but not happy for an increase in industry supply to force prices down

• price competition [price wars, extreme case]– works only in short-term as rivals soon respond

banking, supermarkets, newspapers, energy production and retailing

Holding Companies & Mergers• common ownership through

holding companies reduces competition– eg The Warehouse Group; other examples?

• mergers have to be approved in NZ by the Commerce Commission

Cartel: a colluding oligopolyMonopsony:• single buyer

– Fonterra (dairy), Zespri (kiwifruit) in NZ• globally, these are Monopolistic Competitors

Natural Monopoly• when a single firm can supply the whole

market while experiencing decreasing costs S&R fig 7.15 p.136, S fig 7.18 p.156 (eg Vector)– especially where large networks exist– competition would force each firm to produce at

an above-optimal cost (ie on the left side of the LAC curve)

• monopoly is not always bad– natural monopolies are usually publicly owned or subject

to price regulation to improve their economic efficiency– high cost industries with social benefits will often only be

provided by a monopoly• to operate efficiently, a subsidy may be needed fig 8.2, 8.1

fig 7.14, 7.17 for price regulation

Efficient Quantities for Societyif Price (ie Average Revenue) = Marginal Cost

– price is the marginal benefit of a private good

• 'price (AR) = marginal cost' is a condition for efficiency for society as a whole for a 'private good'– otherwise , efficiency gains can be realised:

• if price > marginal cost, there will be increased net benefits if more resources are allocated to that good

• if price < marginal cost, there will be increased net benefits if fewer resources are allocated to that good and more resources are allocated to other goods

– markets are efficient when changes in quantity supplied can not lead to welfare gains back

Net Benefits• Consumer (household) point of view

happiness – unhappiness = individual welfare

• Producer (firm) point of viewtotal revenue – total cost = profit

• Social point of viewtotal benefit – total cost = societal welfareconsidered from combined point of view:

• private user (first party)• third parties• public (collective)

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Dynamic vs. Static Efficiency

Contrasting effects of Perfect and Imperfect Competition• Market Concentration Ratios

– many industries fall between oligopoly and monopolistic competition, with market leaders

– monopoly = 1; perfect competition = 0

• Evaluation of differences S&R, S Table 8.1

– imperfect competition• can be made more efficient through policy intervention• competition creates marketing industry• dynamic competition – rivalry – creates change

• Issue to think about– do Google and Facebook dominate the Internet?

MultichoiceMonopolyRevision (cb, cc)

Demand Curves Faced by Firms with Different Initial Market Shares

$4.50

$5.00

$5.50

$6.00

$6.50

$7.00

$7.50

160 170 180 190 200 210 220 230 240 250

output (Q) of individual firm

mar

ket-

clea

rin

g p

rice

(P

) p

er it

em s

old

0.1% market share 1% market share 5% market share

20% market share 50% market share 100% market share

Market Demand Curve

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Duopoly

Oligopoly

Monopoly

Average Revenue Curves, Firms in Industries with different levels of competition

economies of scale diseconomies of scale

eg large Supermarket

eg Dairy

eg Superette

eg small Supermarket

$

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Example of a Long-Run Average Cost Curve LAC S&R ch.5