ANALYSIS OF MARKET

STRUCTURE

AIMS & OBJECTIVES

After studying this lesson, you will be able to understand:

Perfect competition
Imperfect competition

Monopoly
Monopolistic competition

Oligopoly
Game theory

PERFECT COMPETITION

FEATURES OF PERFECT COMPETITION

Basic Features Large numbers of buyers and sellers. Product homogeneity. Free entry and exit of firms Perfect information. Perfect mobility of factors of production No government regulation Profit maximization Examples of Competitive Markets Agricultural commodities. Prominent markets for intermediate goods and services. Unskilled labor market.
4

PROFIT FUNCTION

It is given as
Profit = Total revenue- Total cost

Symbolically

= TR - TC

CONCEPT OF NORMAL PROFIT, SUPER NORMAL PROFIT & LOSS

Normal profit = 0 TR = TC Super normal profit > 0 TR > TC Normal profit < 0 TR < TC

PROFIT MAXIMIZATION IN COMPETITIVE MARKETS

Profit Maximization is Imperative Normal profit is necessary to attract and maintain capital investment. Efficient firms can earn normal profit. Inefficient firms suffer losses.
Role of Marginal Analysis Set M = MR MC = 0 to maximize profits. MR=MC when profits are maximized.

SHAPE OF MR, AR AND DEMAND CURVE

IN PERFECT COMPETITION
Price, cost

The AR curve of a seller is the demand curve of the consumer

P
AR= MR

Output
8

EQUILIBRIUM OF A FIRM IN PERFECT COMPETITION/SHORT RUN EQUILIBRIUM

Equilibrium of a firm takes place when the individual firm maximizes profit

Firms are in equilibrium when profit is maximized MR= MC =P =AR

P=MR =AR

EQUILIBRIUM OF A PERFECTLY COMPETITIVE INDUSTRY/LONG RUN EQUILIBRIUM

D

S
P P E E S

Let at the going price P the representative firm in the industry earn supernormal profit as shown by the blue shaded area new firms are attracted to the industry pushing the supply curve to the right. Price starts coming down and the share of profit of each firm starts falling. This adjustment goes on till the time the entire supernormal profit is removed and each firm earns only normal profit (TC= TR) at price P. The reverse mechanism works if existing firms in industry earns losses. Adjustment 10 Happens through exit of firms till normal profit point is arrived at. Thus, industry is in equilibrium at normal profit at the minimum point of AC where AR=MR=MC=AC=P

BREAK-EVEN & SHUT DOWN POINT

Break-even point Shut down point
Break even for a firm occurs at that level of output at which P = min ATC Shut down for a firm occurs at that level of output at which P = min AVC
Q

Firms shut down operations when prices come down to the level at which the Price =min AVC. Hence no output is produced for prices below OP in figure. There is production only if price> OP.

11

MARGINAL COST AND FIRM SUPPLY

Short-run Firm Supply Firms 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 .

12

MONOPOLY

FEATURES OF MONOPOLY

There is a single seller and large number of buyers

The product does not have close substitutes.

Monopolist is a price maker

There are legal/technical /economic barriers to entry

14

WHY MONOPOLIES ARISE

The fundamental cause of monopoly is barriers to entry.

15

WHY MONOPOLIES ARISE?

Barriers to entry have three sources: Ownership of a key resource. This tends to be rare. De Beers is an example The government gives a single firm the exclusive right to produce some good. Patents, Copyrights and Government Licensing. Costs of production make a single producer more efficient than a large number of producers. Natural Monopolies (example: railways, telecommunications, water services, electricity, mail delivery)

16

MONOPOLY VERSUS COMPETITION

A monopoly firm is the only producer while a perfectly competitive firm is one of many firms A monopoly firm has a downward sloping demand curve while a perfectly competitive firm faces a horizontal demand curve A monopolist is a price maker and a competitive producer is a price taker A monopolist sells more at lower price while competitive seller sells as much or as little at same price

17

DEMAND CURVES FOR COMPETITIVE AND MONOPOLY FIRMS

(a) A Competitive Firms Demand Curve Price (b) A Monopolists Demand Curve

Price

Demand

Demand
0 Quantity of Output 0 Quantity of18 Output

A MONOPOLYS REVENUE

Total Revenue:
Average Revenue:

P x Q = TR
TR/Q = AR = P

Marginal Revenue:

dTR/dQ = MR = d(PQ)/dQ= P + QdP/dQ

where, d denotes a small change

19

A MONOPOLYS MARGINAL REVENUE

A monopolists marginal revenue is always less than the price of its good.

MR = d(PQ)/dQ= P + QdP/dQ < P The demand curve is downward sloping. When a monopoly drops the price to sell one more unit,
the revenue received from previously sold units also decreases.

20

DEMAND AND MR CURVE OF A MONOPOLIST

Price Revenue

a
AR / Dd

MR

quantity
21

PROFIT-MAXIMIZATION FOR A MONOPOLY...

Costs and Revenue

2. ...and then the demand curve shows the price consistent with this quantity.
B

MC

price

1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profitmaximizing quantity... AC

AR/Dd
22

MR
0 QMAX

Quantity

PROFIT-MAXIMIZATION FOR A MONOPOLY

Costs and Revenue

MC price

Profit

AC

AR/Dd
23

MR
0 QMAX

Quantity

COMPARING MONOPOLY AND COMPETITION

For a competitive firm, price equals marginal cost.

P = MR = MC

For a monopoly firm, price exceeds marginal cost.

P > MR = MC

24

MONOPOLY POWER

This the power of a firm to change the price of its product through an adjustment in its output The degree of monopoly power, L, called Lerners index of monopoly power is measured as

L = P MC /P

In case of perfect competition P = MC, hence L= 0

Higher the price elasticity of demand of consumers, lower is L

Higher the price elasticity of demand of consumers, lower is L

25

PRICE DISCRIMINATION

Price discrimination is the practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. In order to do this, the firm must have market power.

26

PRICE DISCRIMINATION

Two important effects of price discrimination: It can increase the monopolists profits. It can reduce deadweight loss.
But in order to price discriminate, the firm must Be able to separate the customers on the basis of willingness to pay. Prevent the customers from reselling the product.

27

TYPES OF PRICE DISCRIMINATION

First degree- the practice of charging maximum possible price that the consumers are willing to pay for each of the successive units of the product. Example: applies to any market where discounts from posted prices are normal like professional services, homes. Second Degree- this occurs if the monopolist can divide the buyers of his product into different groups each having a different range of demand prices and charge from each group a price that equals the minimum demand price of that group. Example: electric companies charging block rates Third Degree- here the monopolist divides his market into different sub markets and charges for the product in different sub markets different prices. Example: charging of different rates for an insured patient and uninsured patient

28

MONOPOLISTIC COMPETITION

MONOPOLISTIC COMPETITION

It is a market structure where some features of competition and some features of monopoly are seen to prevail.

30

ATTRIBUTES OF MONOPOLISTIC COMPETITION

Large number of buyers and sellers

Product differentiation

Free entry and exit

Advertising expenditure incurred by firms

31

EQUILIBRIUM UNDER MONOPOLISTIC

COMPETITION
DD- the actual sales Proportional dd
MC

Price Revenue

dd the perceived demand

Quantity
MR corresponding to dd

32

SHORT RUN EQUILIBRIUM/EQUILIBRIUM OF A

FIRM
DD- the actual sales Proportional dd
MC AC

Price Revenue

Profit

dd the perceived demand

Quantity
MR corresponding to dd

33

LONG RUN EQUILIBRIUM/INDUSTRY

EQUILIBRIUM
DD- the actual sales Proportional dd
MC AC

Price Revenue

Firms earn Normal profit

dd the perceived demand

Quantity
MR corresponding to dd

34

MONOPOLISTIC VERSUS PERFECT COMPETITION

There are two noteworthy differences between monopolistic and perfect competition excess capacity
markup

35

EXCESS CAPACITY

There is no excess capacity in perfect competition in the long run Free entry results in competitive firms producing at the point where average total cost is at its minimum. This is the efficient scale of the firm. In monopolistic competition, output is less than the efficient scale of perfect competition.

36

EXCESS CAPACITY
(a) Monopolistically Competitive Firm Price (b) Perfectly Competitive Firm Price

DD

MC

ATC

MC

ATC

P
Excess capacity

P = MC

P = MR (demand curve)

dd Quantity
Quantity produced Efficient scale Quantity = Efficient produced scale

Quantity
37

MARKUP OVER MARGINAL COST

For a competitive firm price = MC
For a monopolistically competitive firm, price > MC.

38

MARKUP OVER MARGINAL COST

Because price exceeds marginal cost, an extra unit sold at the marked price means more profit for the monopolistically competitive firm.

39

MARKUP OVER MARGINAL COST

(a) Monopolistically Competitive Firm Price DD Markup Price (b) Perfectly Competitive Firm

MC

ATC

MC

ATC

P = MC Marginal cost MR Quantity produced

P = MR (demand curve)

dd Quantity
Quantity produced

Quantity
40

ADVERTISING

When the different firms in a monopolistically competitive market structure sell differentiated products and charge prices above marginal cost, each one of them has an incentive to advertise in order to attract more buyers to its particular product.

41

BRAND NAMES IN MONOPOLISTIC

COMPETITION
o A monopolistically competitive market structure is characterized by the existence of many brands o Actually there is brand proliferation that creates an illusion of competition and deters entry

42

BRAND NAMES IN MONOPOLISTIC

COMPETITION
o It is argued that brand names cause consumers to perceive differences that do not really exist. o Brand names may help consumers to ensure that the goods they are buying are of high quality. providing information about quality. giving firms incentive to maintain high quality.

o It is this loyalty of a consumer towards a brand that give rise to monopoly power for an individual firm in monopolistic competition.

43

OLIGOPOLY

OLIGOPOLY

Oligopoly Market Characteristics Few sellers. Homogenous or unique products. Blockaded entry and exit. Imperfect dissemination of information. Opportunity for above-normal (economic) profits in longrun equilibrium. Examples of Oligopoly Carbonated Beverage Market (Pepsico & Coca Cola), Domestic aviation Industry in India (Few Players like Indian Airlines, Jet airways, Kingfisher).

45

TYPES OF OLIGOPOLY

Non-Collusive Oligopoly Cournot Duopoly Model Stackelbergs Duopoly Model Bertrands Duopoly Model Sweezys Kinked demand curve Model Collusive Oligopoly Cartels Price Leadership

46

NON COLLUSIVE OLIGOPOLY

OLIGOPOLY OUTPUT-SETTING MODELS

Cournot Oligopoly
Cournot equilibrium output is found by simultaneously solving output-reaction curves for both competitors. Reaction curve of a firm shows the output that a firm will choose to produce, given the output of the rival firm such that its profit is maximized.

48

Figure explaining Cournot equilibrium optional

49

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 leaders pricing policy. A firm becomes a leader when it is sophisticated enough to know that his rival will always respond according to its own Reaction curve. He takes his output decision accordingly such that given his rival decides according to its reaction curve, the leader firm maximizes its profit with his output decision
50

Figure explaining Stackelberg equilibrium optional

Xb

As reaction function
Xb b

Stackelbergs equilibrium With B the leader

Cournot equilibrium e Stackelbergs equilibrium With A the leader Bs reaction function

Xb

Xa

Xa

Xa

51

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. Bertrand Oligopoly: Differentiated Products The Bertrand model demonstrates how price-setting oligopolists profit with differentiated products.

52

Figure explaining Bertrand equilibrium - optional

53

SWEEZY OLIGOPOLY

Sweezy model predicts sticky prices. Sweezy model explains why prices in oligopoly markets sometimes fail to respond to marginal cost change.

54

55

COLLUSIVE OLIGOPOLY

TYPES OF COLLUSION

Cartels
Price Leadership

57

CARTELS

Aiming at joint profit maximization Market sharing cartels

58

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.

59

PRICE LEADERSHIP

Low cost price leadership Dominant firm price leadership

60

GAME THEORY

INTRODUCTION

Game theory is concerned with the general analysis of strategic interaction. It can be used to study political negotiations, economic behaviour etc Here we shall show briefly how it works & how it can be used to study economic behaviour in oligopolistic market

62

THE PAYOFF MATRIX OF A GAME

Strategic interaction can involve many players & many strategies, but we limit ourselves to two-person games & with finite umber of strategies. We can then depict the game easily in a payoff matrix

Payoff matrix of a game

Player B left right top 1, 2 0, 1 Player A bottom 2, 1 1, 0

63

EXPLANATION FOR THE PAYOFF MATRIX

Person A has two strategies: he can choose top or bottom. They can represent economic choices like raise prices or lower prices
Person B has two strategies: he can choose left or right. They can similarly represent economic choices like raise prices or lower prices The payoff matrix depicts the payoffs to each player for each combination of strategies that are chosen

64

OUTCOME OF THIS GAME

From the point of view of person A, it is always better to choose the strategy bottom. While it is always good for B to choose strategy left. Thus the equilibrium strategy is top for A and left for B. Here top for A and left for B are called dominant strategy. That they are the optimal strategies for A & B respectively irrespective of what the other player does. Thus, here we have equilibrium in dominant strategies of the players & the equilibrium for the players are 2 for A and 1 for B If there is a dominant strategy for each player is some game, then we would predict that it would be the equilibrium outcome of the game

65

DOMINANT STRATEGY IS NOT

ALWAYS PRESENT

Dominant strategy equilibria are good when they happen, but they dont happen all that often. For instance let us consider this game. Here there is no dominant strategy for either A or B. Each of their optimal choice depends on the other players choice

Player B

left 2, 1

right 0, 0

Player A

top

0, 0 bottom

1, 2

66

NASH EQUILIBRIUM

In the absence of dominant strategy, if As choice is optimal given Bs choice and Bs choice is optimal given As choice then the pair of strategies is said to represent a Nash equilibrium. Neither person knows what the other person will do when he has to make his own choice of strategy. They work on expectations about the other player. A Nash equilibrium may be interpreted as a pair of expectations about each persons choice such that, when the other persons choice is revealed, neither individual wants to change his behaviour

67

NASH EQUILIBRIUM CONTD..

In this example top, left is Nash equilibrium. This is because if A chooses top the best for B is to choose left. And if B chooses left the best for A to choose is to. Thus if A chooses top optimal choice for B is left & if B chooses left then the optimal choice for A is top. Thus each is making an optimal choice given the other persons choice i.e. they are at Nash equilibrium

Player B

left
Player A

right 0, 0 1, 2

top
bottom

2, 1 0, 0

68

PROBLEMS WITH NASH EQUILIBRIUM

A game may have more than one Nash equilibrium. In the last game (bottom, right) also represents a Nash equilibrium.
Some games may not have a Nash equilibrium altogether (example on next slide)

69

A GAME WITH NO NASH EQUILIBRIUM

Player B

left 0, 0 Player A top 1, 0 bottom

right 0, -1

-1, 3

70

SOLUTION TO THE LAST GAME

The last game does not have a Nash equilibrium if we think of each agent as choosing a strategy once and for all i.e. if each agent is making one choice and sticking to it. This is called a pure strategy. However, the game will have a solution if the agents used mixed strategies rather than pure strategies A Nash equilibrium in mixed strategies refers to an equilibrium in which each agent chooses the optimal frequency with which to play his strategies given the frequency choice of the other player

71

MIXED STRATEGIES

The agents may randomize their strategies- they may assign a probability to each choice & to play their choices according to those probabilities. For example A may choose top 50% of the time & bottom 50% of the time. Similarly B may choose left 50% of the time & right another 50% of the time. In this case the players will have a probability of of ending up in each of the four cells in the payoff matrix. Thus the Average payoff to A will be 0 & that to B will B .

72

PRISONERS DILEMMA

Another problem with Nash equilibrium of a game is that it does not necessarily lead to Pareto efficient outcomes. Example: the game shown here. This refers to a situation of prisoners dilemma.
Player A confess

Player B

confess -3, -3 -6, 0

deny 0, -6 -1, -1

deny

73

POINTS TO BE NOTED IN THIS GAME

A is always better of confessing & so is B irrespective of each others action. Thus confessing is a dominant strategy. If B confesses it pays A to confess and if A confesses it pays B also to confess. Thus, (confess, confess) is also a Nash equilibrium
However, if both denied it would be better for both of them. Thus, (confess, confess) strategy is Pareto inefficient.

74

EXAMPLE OF PRISONERS DILEMMA IN

ECONOMIC PHENOMENON

Player B

Problem of cheating in a cartel. If you think the other person is going to stick to the quota, it will pay you to produce more than your own quota. And Player A if you think the other firm will overproduce, then you might as well too.

Produce more than quota

Stick to quota a12, b12

Produce more than quota

Stick to quota

a11, b11

a21, b21

a22, b22

75

SOLUTION TO THE PRISONERS DILEMMA

The solution depends on whether one is playing a one-shot game or whether the game is to be repeated indefinitely If it is one shot game confessing seems to be the reasonable solution

76

TWO PERSON ZERO SUM GAME

B's startegies B1
A1 0.1

B2
0.2

B3
0.15

B4
0.3

B5
0.25

A's Strategy

A2
A3

0.4
0.35

0.3
0.25

0.5
0.2

0.55
0.4

0.45
0.5

A4

0.25

0.15

0.35

0.6

0.2

A choose A2 by maxmin strategy & B chooses B2 by minmax strategy. A2, B2 is called the saddle point. It is an equilibrium as it is solution preferred by both. This is the dominant 77 strategy.

78