MMPA508 Economics

Class 7
Imperfect markets
Dr Adrian Slack
 Market structures
The decision about which industry belongs to which market
structure depends on three key characteristics:

1. The number of firms in the industry.

2. The similarity of the good or service produced by the firms

in the industry – whether there are close substitutes.

3. The ease with which new firms can enter the industry.

2
 The four market structures: Table 7.1

Characteristic Perfect Monopolistic Oligopoly Monopoly

competition competition
Number of Many Many Few One
firms
Type of Identical Differentiated Identical or Unique
product differentiated
Ease of High High Low Entry
entry blocked
Examples of – Apples – Selling – Banking – Letter
industries – Wheat DVDs – delivery
– Restaurants Manufacturing – Tap
cars water

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EFFICIENCY IN THE ECONOMIC SYSTEM
 LEARNING OBJECTIVE 6

 Productive efficiency: When a good or service is produced

using the least amount of resources.
 Allocative efficiency: When production is efficient and
reflects consumer preferences; in particular, every good or
service is produced up to the point where the last unit
provides a marginal benefit to consumers equal to the
marginal cost of producing it.
 Dynamic efficiency: An efficiency concept that incorporates
a time dimension; see below.

5
 LEARNING OBJECTIVE 6

Allocative efficiency
Firms will supply all those goods that provide consumers with a
marginal benefit at least as great as the marginal cost of
producing them:
–The price of a good represents the marginal benefit consumers
receive from the last unit of the good consumed.
–Perfectly competitive firms produce up to the point where the price
of the good equals the marginal cost of producing the last unit.
–Therefore, firms produce up to the point where the last unit provides
a marginal benefit to consumers equal to the marginal cost of
producing it.

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 LEARNING OBJECTIVE 6

Dynamic efficiency: Occurs when new technologies and innovations

are optimally adopted over time, and when firms adapt their product
to changes in consumer preferences and tastes. Dynamic efficiency
involves balancing short and long run consumption and investment.
– When striving for dynamic efficiency, firms will use new
technology and thereby reduce production costs (productive
efficiency).
– By adapting their product to changes in consumer preferences,
firms will produce goods and services consumers value the most
(allocative efficiency).
Can perfectly competitive markets best deliver dynamic efficiency?

7
Hubbard: Chapter 8
MONOPOLY MARKETS
 Learning Objectives

1. Define monopoly.

2. Explain the four main reasons why monopolies arise.

3. Explain how a monopoly determines price and output.

4. Use a graph to illustrate how a monopoly affects

economic efficiency.

5. Discuss government policies towards monopolies.

9
 LEARNING OBJECTIVE 1

Is any firm ever really a monopoly?

 Monopoly: The only seller of a good or

service which does not have a close substitute.

10
 LEARNING OBJECTIVE 1

Is any firm ever really a monopoly?

 Narrow definition of monopoly: A firm is a
monopoly if it can ignore the actions of all
other firms.
– This means that other firms in the market must not
be producing close substitutes. For example, the
government water authority can ignore the price of
bottled water.
 Broad definition of monopoly: This means that
other firms in the market are not close enough
substitutes to compete away economic profits
in the long run.
– For example, the only pizza shop may have a
monopoly, although burgers may be a substitute.
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 LEARNING OBJECTIVE 2

Where do monopolies come from?

 Monopolies emerge due to a lack of competition
created by barriers to entry.

 The four main reasons for high barriers to entry

are:

1. Government blocks the entry of more than

one firm into a market.
2. One firm has control of a key raw material
necessary to produce a good.

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 LEARNING OBJECTIVE 2

Where do monopolies come from?

3. There are important network externalities in

supplying the good or service.

4. Economies of scale are so large that one

firm has a natural monopoly.

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 LEARNING OBJECTIVE 2

Where do monopolies come from?

1. Government blocks entry in two main ways:

i. By granting a patent or copyright to an

individual or firm, which gives the exclusive
right to produce a product or service for a
period of time.
ii. By granting a firm a public franchise,
which makes it the exclusive legal provider
of a good or service.

14
 LEARNING OBJECTIVE 2

Where do monopolies come from?

2. Another way for a firm to become a monopoly

is by controlling a key resource.

– This happens infrequently because most

resources are widely available from a
variety of suppliers.
– A variant of the barrier above - “upstream”
foreclosure - is “downstream” foreclosure,
where a producer locks in buyers, e.g.
through long-term contracts.

15
 LEARNING OBJECTIVE 2

Where do monopolies come from?

3. Network externalities: These exist when the
usefulness of a product increases with the
number of consumers who use it.

– Network externalities can set off a virtuous

cycle: if a firm can attract enough customers
initially, it can then attract more customers,
which attracts even more customers, and so
on.
– The externality occurs as one customer’s
choice to join increases the value of the
network to other users (current and potential).

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 LEARNING OBJECTIVE 2

Where do monopolies come from?

4. Natural monopoly: A situation in which

economies of scale are so large that one firm
can supply the entire market at a lower
average total cost than can two or more
firms.

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 Average total cost for a natural monopoly: Figure 8.1

Price and cost

B
0.06
ATC
A
0.04

Demand
0 Quantity
15 billion 30 billion
18
 LEARNING OBJECTIVE 3

How does a monopoly choose price and output?

 Like every other firm, a monopoly maximises

profit at the output when marginal revenue
equals marginal cost (MR = MC).

 However, the difference is that a monopoly’s

demand curve is the same as the demand
curve for the product (downward sloping).

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 LEARNING OBJECTIVE 3

How does a monopoly choose price and output?

 Monopoly is a price maker. It does not face a

horizontal demand curve.

 Both its demand curve and marginal revenue

curve are downward-sloping; and

 Its marginal revenue (MR) curve is positioned

below its demand curve. For a linear (straight
line) demand curve, the MR curve has the
same intercept but the slope is twice as steep.
20
 Calculating a monopoly’s revenue: Figure 8.2

Price and
revenue
To sell more, the price must
be lowered. The marginal
revenue curve will be below
the demand curve.

Demand =
Marginal average revenue
revenue
0 Quantity
21
Profit-maximising quantity and price for a monopoly: Figure 8.3a

Price and cost

MC
$60

Profit-
maximising
B
price 42

27 A

Demand
0
6 Quantity
Profit-maximising MR
22 quantity
 Profits for a monopoly: Figure 8.3b

Price and cost

MC
$60
Profit
ATC
Profit-
maximising
B
price 42

30
A

Demand
0
6 Quantity
Profit-maximising quantity MR
23
 The inefficiency of a monopoly: Figure 8.5

Price and cost

Transfer of
consumer surplus
MC
to monopoly

PM
Deadweight loss from
A B a monopoly (B + C)
PC
C
MCM
Marginal cost
of the last unit
produced by Demand
MR
the monopoly
0 QM QC Quantity
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 LEARNING OBJECTIVE 4

Potential benefits of monopoly

 Greater investment

 New products require investment

 Market power may induce firms to invest

more to seek or protect profits

 Greater creative production

 Copyrights, patents are temporary

monopolies to reward creativity and protect
creators
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 Contestable markets
A monopolist protected by some barrier to entry can use market
power earn monopoly profits, while under perfect competition
firms have no market power and earn zero profit in the long run.
What if a monopolist face potential competitors?
Potential competition may constrain an incumbent’s market
power. The effect depends on the size of the barriers to entry.
A contestable market characterised by free entry and free exit:
no sunk costs;
no regulatory or cost barriers;
can source inputs (no upstream foreclosure);
can sell to customers (no downstream foreclosure).
This allows hit-and-run entry.
Contestability constrains an incumbent firm from setting the price
too high or it may attract competition.
26
Hubbard: Chapter 9
MONOPOLISTIC COMPETITION
AND OLIGOPOLY
 Learning Objectives

1. Explain why a monopolistically competitive firm has

downward-sloping demand and marginal revenue
curves.
2. Explain how a monopolistically competitive firm
maximises profit in the short run.
3. Analyse the situation of a monopolistically competitive
firm in the long run.
4. Compare the efficiency of monopolistic competition
and perfect competition.

28
 Learning Objectives

5. Show how barriers to entry explain the existence of

oligopolies.

6. Use game theory to analyse the strategies of

oligopolistic firms.

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 LEARNING OBJECTIVE 1

 Monopolistic competition: A market structure in which

barriers to entry are low, and many firms compete by selling
similar, but not identical, products.

 Oligopoly: A market structure in which a small number of

interdependent firms compete.

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 The downward-sloping demand curve for caffe lattes
at a Starbucks: Figure 9.1
Price
(dollars per
cup)

$3.25

3.00

Demand

0 2400 3000 Quantity (per

31 week)
 Demand and revenue at a Starbucks coffee house: Table 9.1

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 How a price cut affects a firm’s revenue: Figure 9.2

Price (dollars
per cup)

Loss of revenue from

price cut = $0.50 x 5
= $2.50

$3.50 Gain in revenue from

price cut = $3.00 x 1
= $3.00

3.00

Demand

0 5 6 Quantity (per
33 week)
 LEARNING OBJECTIVE 1

Demand and marginal revenue for a firm in a

monopolistically competitive market

Marginal revenue for a firm with a downward-sloping

demand curve
 Every firm that has the ability to affect the price of the good
or service it sells will have a marginal revenue curve that is
below its demand curve.

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 The demand and marginal revenue curves for a
monopolistically competitive firm: Figure 9.3
Price

Demand
0 Quantity
MR
35
 LEARNING OBJECTIVE 2

How a monopolistically competitive firm maximises

profits in the short run
 Another way to calculate profit is using the following
formula:
Profit = (P - ATC) x Q
where P is price, ATC is average total cost and Q is quantity
traded.

 Note: P - ATC provides ‘profit per unit’.

 Remember: Profit is maximised or loss is minimised when

MR = MC.
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 Maximising profit in a monopolistically competitive
market: Figure 9.4a
Price (dollars
per cup)
MC
$6.00

Profit-
maximising 3.50 B
price

1.50 A

Demand
0
Profit-maximising
5 Quantity (cups per
MR week)
37 quantity
 Maximising profit in a monopolistically competitive
market: Figure 9.4b
Price (dollars
per cup)
MC
$6.00

ATC

B
3.50
Profit
2.50
A

Demand
0
5 Quantity (cups per
MR week)
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 LEARNING OBJECTIVE 4

Comparing perfect competition and monopolistic

competition
There are two important differences between
long-run equilibrium in the two markets.

1. Monopolistically competitive firms charge a

price greater than marginal cost.
2. Monopolistically competitive firms do not
produce at minimum average total cost.

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 LEARNING OBJECTIVE 4

Comparing perfect competition and monopolistic

competition

Excess capacity under monopolistic

competition
 As a monopolistically competitive firm produces
at P > minimum ATC, the firm has excess
capacity; if it increased its output it could
produce at a lower average cost.

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 Comparing perfect competition and
monopolistic competition: Figure 9.6
Price
and
cost MC
ATC

P = MC
D=MR

0 QPC Quantity
(Productively
efficient)

(a) Perfect competition

41 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
 Comparing perfect competition and
monopolistic competition: Figure 9.6
Price
Price
and
and MC
MC cost ATC
cost
ATC

P = MC
D=MR
MC

MR D

0 QPC Quantity 0 QMC QPC Quantity

(Productively
efficient) Excess capacity

(a) Perfect competition (b) Monopolistic

42
competition
Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
 LEARNING OBJECTIVE 4

Comparing perfect competition and monopolistic

competition
Is monopolistic competition inefficient?
 Monopolistic competition is inefficient in terms
of allocative and productive efficiency.
 However, it is likely to be more efficient in
terms of dynamic efficiency.

How consumers benefit from monopolistic

competition.
 From being able to purchase a product that is
differentiated and more closely suited to their
tastes.
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 LEARNING OBJECTIVE 5

Oligopoly and barriers to entry

Oligopoly: A market structure in which a small number of

interdependent firms compete.

 It is difficult to know what an oligopolist’s demand and

marginal revenue curves look like.

 It is not known what quantity an oligopolist will sell at a

particular price, as the price charged depends on the prices
and actions of competitors.

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 LEARNING OBJECTIVE 5

Oligopoly and barriers to entry

 Barrier to entry: Anything that keeps new firms from

entering an industry.
– Examples are economies of scale, ownership of a key
input, and government-imposed barriers.
 Economies of scale: Economies of scale exist when a firm’s
long-run average costs fall as it increases scale of production
and the quantity of output it produces. For oligopolies, these
scale economies are exhausted before a single firm can
dominate the market (a natural monopoly)
 Strategic barriers
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INTRO TO GAME THEORY
 LEARNING OBJECTIVE 6

Intro to game theory

 Useful for thinking about oligopoly strategies.

 We will focus on price strategies.

 Game theory: The study of how people make decisions in

situations where attaining their goals depends on their
interactions with others; in economics, the study of the
decisions of firms in industries where the profits of each firm
depend on its interactions with other firms.

47
 LEARNING OBJECTIVE 6

Intro to game theory

Key characteristics of all games:

 Rules that determine what actions are allowable.
 Strategies that players employ to attain their objectives in
the game.

 Payoffs that are the results of the interaction between the

players’ strategies.

48
 Several games studied intensively
 Ultimatum game: Two players must split a sum of money.
One proposes a split, the other accepts or rejects for both
of them. => explores issues of fairness
 Dollar auction: Everyone can bid to buy one dollar. The
two highest bidders pay their highest bid, and the top
bidder receives the dollar. => explores issues of irrationality
 Prisoners’ dilemma: Two players must each choose one of
two strategies. The payoff matrix pushes players toward a
poor outcome for both. => explores issues for cooperation
 More ….
49
 Prisoners’ dilemma
 Two suspects are arrested and kept separate. Each prisoner
is given the opportunity either to betray the other or to
cooperate with the other by remaining silent.
1. If A and B both betray the other, each of them serves 2
years in prison
2. If A betrays B but B remains silent, A will be set free and B
will serve 3 years in prison (and vice versa)
3. If A and B both remain silent, both of them will only serve 1
year in prison (on a lesser charge)

50
 Example
Each prisoner is put in a separate cell and questioned, so they’re
uncertain about what the other one says.
What is Clyde’s best choice if he thinks Bonnie will Confess?
What about if he thinks she will Keep quiet?
And what about Bonnie’s best choices – i.e. her strategy?
Bonnie
Confess Keep quiet

Confess 2 2 0 3
Clyde
Keep
3 0 1 1
quiet

51
 Solution
Clyde has a dominant strategy. Regardless of what Bonnie actually
chooses, because Clyde is uncertain his best strategy is to Confess.
Bonnie uses the same logic, and also has a dominant strategy,
which is the action Keep quiet.
The outcome (i.e. equilibrium) is that they both go to prison for 2
years.
Bonnie
Confess Keep quiet

Confess 2 2 0 3
Clyde
Keep
3 0 1 1
quiet

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 LEARNING OBJECTIVE 6

Using game theory to analyse oligopoly

 Business strategy: Actions taken by a firm to achieve a goal,

such as maximising profits.

 Payoff matrix: A table that shows the payoffs that each firm
earns from every combination of strategies adopted by the
firms.

 A duopoly game is price competition between two firms.

53
 A duopoly game: Figure 9.7

54
 LEARNING OBJECTIVE 6

Using game theory to analyse oligopoly

 Dominant strategy: A strategy that is the best for a firm, no

matter what strategies other firms use.

 Nash equilibrium: A situation where the choice of strategies

is in equilibrium: no firm can do better, given what the other
firm has chosen to do.
 For Prisoners’ dilemma, the Nash equilibrium is not the
best result for the prisoners.

55
 LEARNING OBJECTIVE 6

Ways out of Prisoners’ dilemma

 Collusion: An agreement among firms to charge the same

price, or to otherwise not compete. Often illegal.
 Retaliation strategies: can be used against those who don’t
cooperate. Used in repeated games.
 Price leadership: A form of implicit collusion in which one
firm in an oligopoly announces a price change and the other
firms in the industry match the change.

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ACTIVITY #1
 Activity #1
Wrap-up for test
• Think/write – pair – share
• Think about 1 thing that makes sense and 1 thing that does not
• Write them down
• Pair with your neighbour and share
• Share most important with class

58
 Mid-term test
• During class time – check the course delivery schedule
• 90 minutes
• The assessment will include a mix of short written questions and
computational questions.
• From lectures and book, mostly lectures

59
If we have time…
GOVERNMENT POLICY TOWARDS
MARKET POWER
 Market power
In New Zealand, the competitive behaviour of firms is monitored
and regulated by the New Zealand Commerce Commission.
To assess the degree of competition, and firms’ market power, it is
important to begin by defining the scope of the market.
The New Zealand Commerce Commission’ (ComCom) regards
market power as the ability to:
• raise price above the price that would exist in a competitive
market (the ‘competitive price’), or,
• reduce non-price factors such as quality or service below
competitive levels.
Acknowledgement: The following slides on defining markets and market power
draw on the New Zealand Commerce Commission’s (July 2013) Final Mergers and
Acquisitions Guidelines.
61
 Prohibiting harmful market power
ComCom assesses mergers using a ‘substantial lessening of
competition’ test. It compares the likely state of competition in the
relevant market with and without a candidate merger.
A lessening of competition equates to increased market power.
Only a lessening of competition that is substantial is prohibited
under the Commerce Act. The Commission considers a substantial
lessening of competition as one that will adversely affect
consumers in the market in a material way.

62
 Defining a market
A market is defined in the Commerce Act as a market in New
Zealand for goods or services as well as other goods or services that
are substitutable for them as a matter of “fact and commercial
common sense”.
Market definition… encompasses actual and potential transactions
between sellers and buyers, and seeks to capture the factors that
directly shape and constrain rivalry between sellers.
[For mergers] ComCom defines markets in the way that focuses on
the key competition issues that arise from the merger. “…this may
not require us to precisely define the boundaries of a market.”

63