CHAPTER 10 PERFECT COMPETITION

Transcription

1 60 CHAPTER 10 PERFECT COMPETITION Assumptions of Perfect Competition The most competitive market structure is pure or perfect competition, which is as competitive as possible. As previously mentioned, market structures are models that summarize how certain markets are organized and behave. For each market structure we have a set of assumptions or characteristics that tell us what kind of industries the model will explain. Only industries that meet the assumptions will behave in the way the model predicts. The assumptions of perfect competition are: Many buyers and sellers: There are so many buyers and sellers in perfect competition that no one of them has any influence whatsoever on the market. The number of consumers and producers is so great that any one of them is like a cup of water in the ocean their presence or absence makes no difference at all to the market. Identical or homogenous product: Every producer in the market makes exactly the same product consumers are not able to distinguish between the output of one firm and the output of another. There are no labels, brands or any other distinguishing features used to make a product look distinct. Excellent information: Both buyers and sellers in this market have good information about the product, especially the fact that there are many other producers all making the same product. Relatively free entry and exit: Firms are able to move resources in and out of this market relatively easily with little expense. This makes firms especially quick to respond to changing consumer demand. As you would expect from this list, there are few markets that come close to fitting these assumptions. The most common example used for perfect competition is agriculture. While agriculture does not fit these assumptions perfectly, it comes closer to perfect competition than to any other market structure. In the major commodity markets, there are so many producers that any one producer has no effect on the market. If you are one producer of hard red winter wheat out of thousands, it does not affect market supply or price if you produce more or less this year. You are so insignificant to the market that you cannot even set your own price, but have the price set for you in the market perfectly competitive firms are price takers, their only choice is to take the market price and sell, or leave it and sell nothing. In the major commodity markets the product is identical from producer to producer there is no difference in the hard red winter wheat of Farmer Smith in Nebraska and Farmer Jones in South Dakota. If consumers were presented with a bucket of each, they could not tell any difference. In the major commodity markets, all the buyers know that the product is identical, they know what current prices are, and they know how to grade the product. If the going price of hard red

2 61 winter wheat were $3 a bushel, a farmer who tried to set his/her price at $3.01 a bushel would sell no wheat. All the buyers know they can get all the wheat they want at $3. Producers have no power over the market price. In the major commodity markets there is relatively free entry and exit, stress on the word relatively. While it is expensive to enter and exit farming in general, it is relatively inexpensive to move from one agricultural market to another related one. For example, areas suitable to growing corn are generally also very suitable to grow soybeans. Similar equipment is used to plant, cultivate and harvest corn and soybeans. If corn prices have been low, corn farmers could easily switch to growing soybeans the next year. In recent years we have seen a growing deviation from the perfect competition pattern in agriculture in that the buyers of agricultural crops are consolidating in some markets. For example, there are a limited number of meat processors that handle pork and poultry reducing the competition on the buying side of the market. In time, we may have to adjust our interpretation of at least some of the agricultural markets, but for the moment the best fit still appears to be perfect competition. In general, the pattern for this market is a very large number of small powerless producers making absolutely the same product in a market where they have no influence on price. Competition is so great that individual firms have no alternative but to operate efficiently in order to survive. The Perfectly Competitive Model in the Short-run In the graph on the left one can see that the price of a product, here wheat, is determined by the overall market supply and demand. Once the price has adjusted to the supply and demand in the commodities market, the current going price of wheat has been established, here $5. From the point of an individual producer, this going market price is set for them and it appears to them that they can sell any quantity of wheat they wish at this market price, but cannot charge one cent over or they will sell nothing at all. The demand curve they face is perfectly elastic. The Wheat Market Individual Wheat Producer 7 6 S 7 6 Price D Price D Quantity of Output Quantity of Output

3 62 Price This is the only market structure where the demand curve facing an individual producer is perfectly elastic. This is also the only market structure where the firm s marginal revenue curve is the same as its demand curve. Remember that the marginal revenue is the change in total revenue (P x Q) divided by the change in quantity of the good. Since we never have to lower price to sell another unit, every unit adds a constant amount to total revenue, here $5. Once we have the marginal revenue curve, we only need a marginal cost curve to predict the profit maximizing point of production (Q*). This producer would want to set Output Determination production where MR = MC, a quantity of 550 bushels. Farmers will decide how much to plant at the beginning of the season based on an MC estimate of the price they expect at the end of the year. This price will be developed from the prices of the MR previous year or two, current planting estimates, current weather forecasts etc. The futures commodities market provides an invaluable service, both because it has thousands of participants factoring in these variables, but also because it allows farmers to lock in a price in the future. This takes the risk off of price and puts it on production the farmer has committed to selling a certain quantity Quantity of Output at the futures price on the specified date. Price Output Determination $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 MC MR ATC Quantity of Output If we added the average cost curve, then we could calculate the profit of the perfectly competitive firm. At a price of $5, this firm is best producing 550 bushels. If they make 550 bushels then the average cost per bushel is $4.50. This means the firm is making a profit on each bushel of $.5 the $5 price minus the $4.50 cost. Since the firm is making $.5 a bushel on 550 bushels, the firm s profit is $275. Remember, this is an economic profit they are making $275 more than they could growing the next best crop. Use the following steps to find profit for any price in a perfectly competitive market. Draw a horizontal line at the going price that is the MR curve. Find the point where MR = MC to establish Q*. Come up from the Q* quantity until you hit the ATC that is the cost per unit. The price minus the cost per unit is the profit per unit. Unit profit times Q* gives the total profit.

4 63 $11 $10 $9 $8 $7 $6 $5 $4 $3 $2 $1 $0 Economic Profit Levels MC ATC AVC Calculate the production level, average cost and economic profit for this perfectly competitive firm if the going market price is $8.50. $5.50. At $8.50 this firm made a positive economic profit; however, at $5.50 the firm made a negative economic profit. As price falls the positive economic profit gets smaller and smaller until it eventually disappears and becomes negative. There is a specific point that separates the range of prices that results in positive economic profit from the range of prices that results in negative economic profit. That point is known as the breakeven point this is the point where the firm makes zero economic profit, or a normal rate of return. If the firm is producing at this level, it must be a Q*, which means that MR = MC. If there is zero economic profit, then P = ATC. In perfect competition P = MR. Put these facts together and you have that ATC = P = MR = MC. There is only one point on this curve where the MC and the ATC curve intersect. That is the breakeven point. In any perfectly competitive firm s graph, the breakeven point is always located at the bottom of the ATC curve where ATC intersects MC. At all prices above this the firm will make positive economic profit; at all prices below this the firm will make negative economic profit. The reaction of the firm to negative economic profit depends on the time horizon. The firm does not have the option of exiting the industry in the short run - in the short run the firm is stuck with some of its factors of production and therefore some of its costs. The firm s only option is to stay open or close down. If it stays open, it will make the profit that exists at Q* even if that is negative. If it shuts down, it will automatically lose an amount equal to its fixed costs because if it shuts down both revenue and variable cost disappear but fixed costs remain. The firm s short run decision to produce or not is based upon where does it lose the least amount of money. If the negative economic profits of Q* are less than negative economic profits of losing FC, the firm will remain open.

5 64 Since ATC = AFC + AVC, then the firm will lose an amount exactly equal to FC if and only if the price of the product is equal to the AVC. At that point the revenue of the firm is just sufficient to pay for the costs of staying open the variable costs. There is no revenue left over to pay any of the FC. At that point the firm would lose the same amount of money whether it stayed open or shutdown. This is known as the short-run shutdown point. If the firm is producing at this level, it must be a Q*, which means that MR = MC. If the firm covers its variable costs but not fixed, P = AVC. In perfect competition P = MR. Put these facts together and you have that AVC = P = MR = MC. There is only one point on this curve where the MC and the AVC curve intersect. That is the short-run shutdown point. In any perfectly competitive firm s graph, the shutdown point is always located at the bottom of the AVC curve where AVC intersects MC. At all prices below the short-run shutdown point the firm would be better to close operations and swallow their fixed costs - the price will not even cover the costs of remaining open. At all prices above the short-run shutdown point the firm would be better to remain open the price will cover the costs of remaining open and something extra to pay for part of the fixed costs. For example, you raise beef cattle and the price of beef falls so low it does not cover your feed bills, labor costs and vet bills. You will sell or slaughter your young stock and have no beef to sell later in the year. When the US government under President Nixon put price ceilings on common consumer necessities like food, including beef, but did not put ceilings on the feed, cattle medicines, electricity for heating barns, etc, farmers slaughtered their young stock and all but the best of their breeding stock. The US had a lot of beef for a few months and then a severe shortage for a couple of years until the herds could be bred back up. As soon as the price ceilings were taken off, the price of beef skyrocketed. Under the controls the ranchers were operating below the short-run shutdown point. Suppose the price of beef were low enough that we covered the costs of maintaining the herds but not enough to cover property taxes, long term barn maintenance and make a normal return on our investment. We are above the short-run shutdown price but below the breakeven price. We would not slaughter our herds in the short run as we would be better off to continue selling beef as normal. Economic Profit Levels MC Breakeven Pt. ATC SRSD Pt. AVC

6 65 The Perfectly Competitive Long-run Equilibrium In the long run, perfectly competitive firms will not continue to produce at a negative economic profit. If they could make more money elsewhere and it is relatively easy to exit the market, that is exactly what some of them would do. As those firms leave the industry, the price will rise for the remaining firms this process will continue until all negative economic profits have been eliminated. If a farmer is consistently growing corn for an 8% accounting profit and could grow soybeans for a 10% accounting profit, then he is making a 2% economic profit. He/she will finish the current corn crop and then plant soybeans. This changes the market supply of both corn and soybeans, reducing the first and increasing the second. This pushes the price of corn up and the price of soybeans down until, relative to the cost of producing them, they both yield the same accounting profit. CORN One Corn Farmer S2 S1 D2 D1 D While the market supply of corn decreases, an individual farmer who continues to grow corn will see the demand for his/her corn rise with the new higher market price, reducing the negative economic profit. Exit will continue until there are no negative economic profits left. SOYBEANS One Soybean Farmer S1 S2 D1 D2 D While the market supply of soybeans increases, an individual farmer who already grew soybeans will see the demand for his/her soybeans fall with the new lower market price, reducing the positive economic profit growing soybeans. Entry will continue until there are no positive economic profits left.

7 66 Exit eliminates negative economic profits and entry eliminates positive economic profits. Perfectly competitive firms makes zero economic profit in the long run. Remember that the breakeven point is at the bottom of the ATC curve so perfectly competitive firms are driven to the lowest possible average cost, all other things equal there is no way to be more efficient. What if all other things are not equal? What if the firm experiences economies of scale? The firm will move from one average total cost curve to another as it expands its capacity. Eventually, it will reach ATC curves that exist at the most efficient scale and then the firm will be pushed to the breakeven point on that ATC curve. Let s take the long run cost curve from chapter 3 and combine it with our current analysis. $ Plant 1 LRAC (Long-Run Average Cost) Economies of Scale Plant 2 Plant 3 Diseconomies of Scale Constant Returns To Scale Q Scale When the firm is moving toward the breakeven point operating with the 1 st plant, we reach a point where it is cheaper to shift to a larger plant, plant 2, than to continue expanding production in plant 1. As we move closer to the breakeven point operating the 2 nd plant, we also reach a point where it becomes cheaper to expand the size of the company again. Finally, with the 3 rd plant we reach not only the minimum average cost on the short run curve, but also the minimum average long run cost as well. Now the firm is operating at the minimum average cost possible in this industry. When the Classical economists modeled the efficiency of the free market system and discussed how responsive it was to consumers, what they really had in mind were perfectly competitive or almost perfectly competitive industries. The problem is that there are very few of these industries in the economy. Journal Topics: Complete the following assignment. Minimum of 2 pages Richard Salsman has been heavily attacking the perfectly competitive model as the basis for government antitrust law. Read and critique his representation of the model in the handout.

8 67 CHAPTER 11 MONOPOLISTIC COMPETITION Equilibrium in Perfect Competition and the Other Market Structures Once we are out of perfect competition, certain features are common to all the remaining market structures. The demand curve for a firm s output is downward sloping, i.e. the firm will have to lower price in order to increase sales. This means that the marginal revenue curve is a different curve, distinct from the demand curve. These two features will lead the other market structures to select an output level that is not socially optimal. All other things equal, the three other market structures will not be as efficient as perfect competition. All other things equal (no externalities, public goods or other market breakdowns), the demand curve represents the value of a good or service to society. Remember the discussion of consumer surplus in chapter 2 any point on the demand curve represents the value of the last unit bought to consumers so the demand curve summarizes the value of all the previous units. All other things equal, the supply curve represents the cost of a good or service to society, including the alternative production sacrificed. In perfect competition the demand curve is also the marginal revenue curve, so when a perfectly competitive firm has a horizontal demand curve set at the market equilibrium price, it is setting Q* at the point where the marginal benefit the good to society is equal to the marginal cost of the good to society. This is not the case in the other three markets. Perfectly Competitive equilibrium Perfectly Competitive equilibrium MC MC Firm's D Mket D The intersection of the MC curve the representation of social cost and the market demand curve the representation of social benefit is the socially optimal point of production. Each individual firm in this market sees a horizontal demand curve set at the equilibrium price. Since the firm s demand curve is also its MR curve, the firm will set its production accordingly. The firms are all using the MC curve as their supply curve and end up at the socially optimal equilibrium. This is the only market structure where that is true. Once you are out of perfect competition, the individual firm sees a downward sloping demand curve and a separate marginal revenue curve. Firms are price makers they have some power over their own price. They will not be using the MC curve as a supply curve they will not come over horizontally from the price to the MC curve to establish the level of production. Since Q* is

9 68 being set by MR and MC not supply and demand their equilibrium will not be the socially optimal decision. Because a firm in any of the other three market structures must lower its price to sell more units, the marginal revenue curve is set below the demand curve. Imagine you are currently selling 500 units a week at a price of $3 a unit for a TR of $1500. If you want to raise your sales, say to 1000 a week, you must lower your price. If price had to be dropped to $2.00 in order to sell 1000 a week, then TR would be $2000. The marginal revenue would then be $500/500 units or $1. The MR is less than either the old or new price. Even though we added 500 units to sales, we dropped the price on the existing sales by $1 lowering the benefit to revenue. P Non-Perfectly Competitive equilibrium Q* MC MR Firm's D The non-perfectly competitive firm will still maximize profit at the point where MR = MC. In perfect competition that was where the firm s demand curve intersected MC but here it is at a lower Q. The non-perfectly competitive firm will then set price at the maximum level consumers will pay for Q* which is set by the demand curve. Because we have reduced the equilibrium Q, we have pushed up the equilibrium P. From a social point of view, the benefit to consumers justifies making more units up until the demand curve intersects the MC curve, but from a business point of view such an expansion would not be profitable. There is a loss of benefit to society a deadweight loss that occurs from the lack of competition. The deadweight loss is the lined triangle. These non-perfectly competitive markets end up with higher prices and less output, all other things equal. They will not be pushed to a long run equilibrium that combines a lack of excess profits with the lowest possible average cost of production. The bottom of the ATC is the intersection point with the MC curve, if we are producing at maximum efficiency then ATC = MC. Since MC must equal MR and MR is less than P, we would have excess profits in the industry. If we have zero economic profit, then P = ATC, but P is greater than MR, while MR = MC. MC would then be less than ATC and we would be producing for a higher average cost than the minimum. The structure of non-perfectly competitive markets is less efficient than perfect competition. M onopolistic Competition The first of the non-perfectly competitive markets is known as monopolistic competition this is a market structure marked by a high degree of competition it s just not perfectly competitive. Each individual company has its own version of a product, so in one respect it is the only seller of this version. However, this version is very similar to the other goods in the market so there is a large amount of competition. Numerically, this is by far the most common market structure in the US as most proprietorships are in monopolistic competition, and proprietorships are the most

10 69 common form of business organization in the US. These firms, however, do not have strong individual power. The assumptions of monopolistic competition are: Many buyers and sellers: There are so many buyers and sellers in monopolistic competition that no one of them has any significant influence on the market. The number of consumers and producers is not as great as in perfect competition but is still sufficient to be very competitive. Similar or heterogeneous product: Every producer in the market makes a similar, but not identical product consumers are able to distinguish between the output of one firm and the output of another. There can be labels, brands or any other distinguishing features used to make a product look distinct a process known as product differentiation. This is the biggest difference between perfect and monopolistic competition. Relatively good information: Both buyers and sellers in this market have information about the product, but not as good as in perfect competition. Because the products are somewhat different, each one has to be investigated separately and consumers do not usually have the time or inclination to do those completely. Instead, we rely on word of mouth, trial and error and advertising in order to find goods we are satisfied with. We do not generally proceed to the point that we know we have the BEST product for the money. Relatively free entry and exit: Firms are able to move resources in and out of this market relatively easily with little expense. This makes firms especially quick to respond to changing consumer demand. This can be a highly competitive market and consumers usually fare well under monopolistic competition. There are many producers of a similar product not only is there good competition, but there is great variety in the nature of the product. This gives consumers a lot of choices. Product differentiation involves a number of business activities. We may vary the physical properties of the product adding scents, flavors, textures and colors, changing the shape of the product or the materials it s made of. You can buy soap that has oil added to protect dry skin or soap that has agents in it to strip oil from oily skin. You can buy soap that is yellow or blue or pink. There is soap that smells like roses and soap that smells like lavender and soap that smells like pine. There is soap that has oatmeal in it to remove dead skin or ground up rock in it to remove embedded dirt by removing the top layer of skin. You can buy soap that is pressed into the shape of seashells or roses. We can vary the service offered, either as an independent service or in combination with a good. We can have a 24-hour store, or free delivery or an extended warranty. Out tech support people can come to your house and move all your old programs onto your new computer. We can accept returns, no questions asked, or special order material. Stores can be located on major streets with drive through windows. Finally, we can vary the marketing. The product and service itself might not have any substantive differences but we could change the package and labeling. Advertising might be used to give our product a certain image that other versions of this product lack. Prestige and status, attractiveness and sex appeal, safety and reliability, economy and thriftiness are all common themes stressed in the image of certain products. Generally, major investments in this kind of marketing are most

11 70 seen in the next market structure, but to a lesser extent it can be found in monopolistic competition. Product differentiation gives consumers a range of choices in the product and service. It is likely, however, to also raise the cost of production. All other things equal, the cost per unit of producing goods with special features or extra service will be greater than the cost of making all the goods exactly alike with the minimum features necessary. All other things equal, the money spent on advertising, packaging and labeling will raise the cost per unit of the good. All other things equal, the entire ATC curve is higher with product differentiation. Advertising may allow the firm to increase its size and enjoy economies of scale. In this case the advertising might result in a more efficient company rather than a less. Since monopolistic competition is generally marked by smaller companies that operate in a highly competitive industry, it seems likely that the economies of scale are limited. Large economies of scale tend to result in very large producers and that seems more relevant to the next two market structures. S hort-run equilibrium in Monopolistic Competition In monopolistic competition the production decision will look like this. Q* is set at the intersection of the marginal cost and marginal revenue, while P is set by the demand curve at Q*. If we add an average total cost curve to the graph, we can calculate the cost per unit of Q*. Short-run equilibrium in Monopolistic Competition Short-run equilibrium in Monopolistic Competition P MC Firm's D ATC MC ATC Firm's D MR MR P ATC Q* Short-run equilibrium in Monopolistic Competition Q* MC MR ATC Firm's D Q* The firm makes a profit on each unit equal to the price minus the unit cost. This is the vertical distance between the demand and ATC curve at the Q* quantity. The firm s total profit is the profit per unit times the number of units Q*. Since Q* is the horizontal distance from the vertical axis out to the Q* quantity, total profit is the area of the rectangle as shown to the left. The height is profit per unit, the width is the number of units and the product (the area) is the total profit.

12 71 Long-run equilibrium in Monopolistic Competition The same process works in monopolistic competition that we see in perfect competition. Relatively free entry and exit will push the industry to a breakeven point. The breakeven point is not located in the same place, however. In the long run, monopolistic competitive firms will not continue to produce at a negative economic profit. If they could make more money elsewhere and it is relatively easy to exit the market, that is exactly what some of them would do. As those firms leave the industry, the price will rise for the remaining firms this process will continue until all negative economic profits have been eliminated. In the long run, monopolistic competitive firms will not continue to produce at a positive economic profit. If they are making more money than elsewhere and it is relatively easy to exit and enter the markets, that is exactly what some of the firms will do in the other industries. As those firms exit their market and enter this market, the price will fall for the original firms this process will continue until all positive economic profits have been eliminated. P = ATC Short-run Long Run equilibrium Equilibrium in In Monopolistic Competition MC ATC The monopolistically competitive firm on the left is at a breakeven point. The firm sets production at Q* - the point where MR = MC. The demand curve establishes P, but since the ATC curve is tangent to the demand curve at that point, the P = ATC. We are breaking even. Q* MR Firm's D Notice that the firm, although breaking even, is not operating at peak efficiency. There is room to lower the ATC by expanding production; however, in order to sell the good the price would have to fall even more. Expansion is therefore not profitable and does not occur. This is the trade-off in monopolistic competition consumers gain variety at the expense of some efficiency. If the product differentiation raised the ATC curve, then consumers lose even more efficiency. Journal Topics: Complete the following assignment. Minimum of 2 pages 1) Find several examples of product differentiation and describe them. Use examples with different kinds of differentiation. 2) Describe several industries that would fall under the monopolistic competitive model.

13 72 CHAPTER 12 OLIGOPOLY Characteristics of Oligopoly Oligopoly is the first of the market structures that is marked by a limited degree of competition. Oligopoly covers a multitude of markets from those that are fairly competitive to some that have very little competition at all. Consumers will face more limited choices in oligopoly and it is within this market structure that the balance of power shifts against the consumer. This is the market structure containing the industries that drive the US economy. The major corporations are in this market structure, and although they are not as numerous as monopolistic competitive firms, they are far larger, more powerful and account for more production. These companies often hold significant political influence in addition to their economic influence. The assumptions of oligopoly are: Relatively few sellers: There are few enough sellers in oligopoly that they can individually have influence on the market. Producers in oligopoly are interdependent a firm s success can be as influenced by the actions of a competitor as its own. The cut-off for oligopoly is arbitrarily chosen to be a concentration ratio of.4 or over. In other words, if the top four firms in the industry have 40% of sales or more, then it is considered to have relatively few sellers. When firms are this large and control this much market share, then the actions of one significantly affects its competitors. Identical or Similar product: In some oligopolies, such as the steel industry, the product can be identical from producer to producer. In other oligopolies, such as the auto industry, the product is only similar from company to company. AOTE, the more similar the goods the more competitively the market will behave. This is because it is easier for consumers to switch from one good to another reducing the firm s power over price. Good or poor information: Both buyers and sellers in this market could have good information about the product or not. Good information is more likely to occur when the products are identical or very similar. The more differences between versions of a good the more data the consumer has to gather to have good information for comparison. AOTE, the better the information the more competitively the market will behave. Firms will be pressured to keep quality and price in line with other producers if they fail to do so, consumers have the knowledge to go buy the better value. Barriers to Entry: Firms are not able to move resources in and out of this market relatively easily with little expense. The barriers to entry are of two types. Artificial barriers: artificial barriers to entry keep new firms from entering even if they wish to. These are generally structural features that make entry difficult or impossible. Artificial barriers to entry include patents, government licenses, control of a raw material, network advantage (where the size of a system of associated services is part of the attractiveness of the good) and high start-up costs.

14 73 Natural barrier: there is one natural barrier large economies of scale that discourages new producers from even trying to enter. There is such a cost advantage to being big that a few huge firms control this market. A new producer is reluctant to enter because they can t produce for as low a cost. Oligopolies vary in the degree of competition some are competitive enough that they are only slightly different than the least competitive firms in monopolistic competition. Some are uncompetitive enough that they are almost a monopoly. While there is disagreement among economists on any rule of thumb to categorize oligopolies, we will use the following generalizations. Concentration ratio of.4 to.6 Concentration ratio of.6 to.8 Concentration ratio of.8 or over Weak Oligopoly, not strongly concentrated Standard Oligopoly neither weak nor strong Strong Oligopoly, strongly concentrated Competitive Oligopolies If an oligopoly market has at least a moderate number of producers that are truly competing with one another i.e. no cooperation and no basis for anticipating the decisions of the other firms - they may exhibit an unusual shaped demand curve. Suppose you are running a firm in such a market, and you are considering changing your price as you search for the profit maximizing point of production. You have to consider how your competitors will react when you change price, because that reaction will change the profitability of any decision you could make. You are currently selling 600 units a week at a price of $6. You are not sure that this is the profit maximizing point of production and are considering change price to find out. You could lower price and hope to make up on volume what you lose on profit per unit; you could raise price and hope that the higher profit margin makes up for a drop in sales. The effect you see will depend on whether the other firms in the industry ignore your price change, keeping theirs about where it was before or match it. In this case the competition decided to ignore your price change. If you raise Competition Ignores price you will be the only firm to do so and you will see a large drop in sales. $12 Some of your consumers are going to go $10 buy the product from someone else. If you lower price you will also be the $8 only firm to do so and you will see a $6 large rise in sales. The demand curve is $4 relatively elastic. Price $2 $ Quantity of Output D If this were the situation in the market, it would suggest that you either leave prices alone or cut them. A price increase is very unlikely to raise profits; on the contrary, it will probably lower them.

15 74 Price $12 $10 $8 $6 $4 $2 $0 Competition Matches D Quantity of Output In this case the competition decided to match your price change. If you raise price, so too do the other firms and there will be a small drop in sales. Consumers have nowhere to go but out of the market. If you lower price, the other firms will match you and you will all gain very few sales, only receive less profit per unit. The demand curve is relatively inelastic. If this were the situation in the market, it would suggest that you either leave prices alone or raise them. A price decrease is very unlikely to raise profits; only the consumers win a price war. Since these two possibilities suggest two contradictory price policies, the question becomes which is true? The answer might be both of them, depending on the nature of the price change. Oligopoly firms which are truly competing may match a price decrease but ignore a price increase. Game Theory To see why a price decrease would be matched while a price increase is ignored, we can model the decision making of the firm. The firm controls part of what goes on in the market, but in an environment of no cooperation or shared information does not know what decisions will be made at the other firms. It must consider each scenario that would occur depending on the different combinations it and the others could select. Game theory is a way of representing the various options available to a decision maker and then showing how they tend to select strategies. In some cases there is a clear choice - no matter what the other side does, this choice is the best for the firm - this is known as a dominant strategy. In other cases the best choice is unclear since it depends on the decisions made by the other player(s). It isn t very useful to model the dominant strategy because if it is the best choice regardless of the decisions of the other firms, then there is no reason to study their decisions and the impact they will have. It is the case where there is no dominant strategy that game theory excels in showing why firms may make a decision which in the aggregate is not the best selection, but on the individual level may be. Suppose that Honda announces it will increase car prices next quarter (assume the auto industry meets the competitive criteria). The management at Ford is considering whether or not they should follow Honda and increase prices as well. The results at Ford will be affected by the decisions made, not only at Ford but also General Motors, Toyota, and the other car companies.

16 75 Suppose Ford's current profit is $4 million and the following reflects Ford's best estimates of what will happen to Ford under the different possible outcomes: GM AND OTHERS RAISE PRICE GM AND OTHERS DON'T RAISE PRICE FORD RAISES PRICE Higher car prices in general mean consumers have few choices. Each company loses some sales but not a lot. Ford's profit $5 million Only Ford and Honda have the new, higher prices. They lose market share to everyone. Ford's profit $3.4 million FORD DOESN'T RAISE PRICE Only Ford has older, lower prices. Ford steals market share from all the other companies. Ford's profit $4.6 million Only Honda has the new, higher prices. Ford and the other car companies steal market share from Honda. Ford's profit $4.1 million There is no dominant strategy here, Ford would do best raising prices IF it knew GM and the other companies would as well. Given that this is a dangerous strategy for a firm to attempt - they could also end up with the worst outcome; a company in this situation is most likely to take the safe strategy - Ford cannot lose maintaining the old prices here. They will probably not follow Honda, unless they can acquire some information about or cooperation with GM and the other companies. The Kinked Demand Curve Price $12 $10 $8 $6 $4 $2 $0 Kinked Demand Curve D Quantity of Output If firms ignore a price increase then the demand curve will be fairly flat or elastic at prices higher than the current one. If firms match a price decrease then the demand curve will be fairly steep or inelastic at prices lower than the current one. This gives us a demand curve that is bent or kinked. The bend occurs at the existing price in the market. In this situation, the firm is best leaving the price where it is. Prices in such a market will be very stable unless underlying costs change or the whole demand curve shifts significantly.

17 76 Price Leadership It s understandable how the corner or kinked price persists, but how did the industry establish the corner price to begin with? In some industries there is an acknowledged leader a firm which is looked to by the other firms when it is time to set a new industry price structure or technology. This may be because of its size, or technological dominance, or history. In times of turmoil, when external forces such as a changing technological base or significantly changing consumer demand render the old equilibrium obsolete, firms will look to this leader to establish the new stable order in the industry. But, we may have now relaxed one of the assumptions under the competitive oligopoly model that there is no basis for anticipating the decisions of the other firms. The industry leader has a past precedent that other firms follow its lead it may decide to risk raising price when there are no external forces at work. Kellogg s is the leader in the cereal industry. If Kellogg s knows that every time corn prices change, General Mills and General Foods follow Kellogg s lead in setting the new price and the timing of the price change, then Kellogg s knows there is a good possibility that they will follow its lead if it raises cereal prices when costs aren t rising. The likelihood of this happening is related to the number of major firms in the industry. If there are only 3 or 4 dominant firms, then if one changes price the other three only have to worry about what 2 other firms are going to do. The probability of a firm taking the risk to follow a price increase by one competitor is much higher if the number of businesses in the industry is small. Traditionally, in the cereal industry there were only 3 producers making about 85% of the output. This can lead to the industry leader essentially setting price for the entire industry a phenomenon known as price leadership. Price leadership can be used as a way of establishing a near monopoly price as long as the other firms do not use the opportunity to gain short run sales at the expense of long run profit. Provided the firms do not actually coordinate their strategy, it is unclear if this behavior is illegal. Anti-trust Law and Collusion By the late 1800s, the Federal government was becoming concerned about the noncompetitive behavior of some American firms. Some companies were cooperating to establish trusts legal agreements that coordinated the production, pricing and distribution decisions of separate companies in a way to remove choice from consumers and establish high prices. A company literally signed over these decisions to a group of trustees to run the industry to the benefit of the major producers. Small or independent producers were run out of the market by a variety of tactics which by the best interpretation were unethical. Powerful monopolies were also rising during this time period people like Rockefeller were establishing the one company domination of industries like oil refining. Again, this reduces the choices available to consumers, increases price, as well as reduces production and probably quality. Because of this the government passed laws to limit the ability of firms to behave in uncompetitive ways, and these were known as anti-trust laws.

18 Sherman Anti-Trust Act: The Sherman Act made it illegal for firms to restrain trade and conspire to create a monopoly in interstate commerce. There were several loopholes in the Sherman Act that weakened its impact. First, only monopolizing behavior in commerce over state lines was illegal. Second, the term "restraint of trade" was not clearly defined. Price fixing, where firms cooperate to establish price together, also known as collusion, was one activity clearly considered to be restraining trade, and therefore illegal. Third, it only outlawed trying to create a monopoly, not having one. In other words, the government had to demonstrate that you behaved in ways designed to eliminate competition; it was considered acceptable to have a monopoly by consumer choice. Although weak, and not upheld by all Presidents or the Courts in general, the Sherman Act was not useless. Theodore Roosevelt was able to break up several powerful trusts or monopolies (like Standard Oil) armed with nothing more than the Sherman Act Clayton Act: The Clayton Act more specifically outlawed activities that were considered to threaten competition. The Clayton Act makes illegal to engage in: tying contracts: These require a customer to buy goods they do not want, in order to acquire the good that they do want. interlocking directorates: These exist when some of the same individuals serve on the Board of Directors for competing companies. price discrimination: This is the practice of charging one set of customers a very different price than another set, without a demonstrable cost basis. The Clayton Act also granted labor unions an exemption to anti-trust law and limited the scope of mergers. If a merger significantly reduces competition in an industry, the firms must seek the approval of the government before combining Federal Trade Commission Act: The FTC Act created the Federal Trade Commission, whose role it was to oversee the level of competition and to investigate mergers. In the early days of the commission, they had broad powers to define "unfair" business practices and then issue cease and desist orders to stop the activities. Later these powers were trimmed, but the FTC was also given regulatory authority over advertising. They are the agency which oversees mergers and must grant approval for significant mergers. The FTC typically uses the Herfindahl- Hirschman Index to decide if the merger should be blocked typically if the HHI is over 1800 or rises by more than 200, the FTC is reluctant to allow a merger to occur. Throughout much of the early 20 th Century, the courts were disinclined to uphold anti-trust law with any vigor. The "Rule of Reason" was a legal precedent used to limit the scope of the laws and make it more difficult for the government to prove its case. The rule of reason basically said that the government had to prove that the noncompetitive structure of the market had been deliberately sought rather than the result of natural market force. In other words, it was fine to have a monopoly or powerful oligopoly if it occurred without intention as the result of making a good product at a good price. Essentially, the government had to prove that consumers were being hurt by the anti-trust violations. The rule was abandoned in the 1945 Alcoa case, where Alcoa lost even though their product was good, prices were low and customers were satisfied. By the 1980s the rule is sneaking back into interpretations of the law and is a key part of the debate over the Microsoft case. Is the purpose of anti-trust law to protect firms against large competitors or to protect consumers against noncompetitive markets pushing price up and quantity/quality down?

19 78 Cartels US anti-trust law regulates the behavior of American firms or foreign firms doing business in the US, but our laws do not have jurisdiction over foreign firms operating in foreign countries. In some parts of the world companies or governments have created cartels - formal organizations to control the production and, therefore, price of a commodity. The track record of cartels is a mixed bag with a few being very successful and many struggling to coordinate the cooperation. OPEC, the Organization of Petroleum Exporting Countries, is among the best known of the cartels. Formed in 1960, OPEC is infamous for the large crude oil price increases it was able to achieve in the 1970s triggering simultaneous serious unemployment and inflation stagflation - in the US economy. OPEC however, saw its control of oil markets erode in the 1980s and 1990s, only successfully bringing oil prices back near their 1981 highs at the turn of the century. In order to be successful, cartels need to have certain factors on their side. In some years OPEC had these and in others they did not. Control of the market: In order to be successful, a cartel must have sufficient control of the market to be able to dominate production level and price. If the cartel does not sufficiently control the market its production cuts will merely boost price for nonmembers. The greater the control the better, but a cartel probably needs about 75%- 80% control of an industry to truly be successful in the long-run. Ability to enforce production agreements: Cartels raise the price of the good they sell by limiting the production of it. This is one of the greatest challenges of any cartel, trust or collusive conspiracy keeping the agreement. There is an incentive for the individual members to cheat on their production quota. If I produce more while everyone else follows the accord, then I get both the high price and high sales. Since everyone faces the same temptation it is likely that cheating will occur this is known as the cartel problem. There are a couple of ways that this issue can be reduced or controlled. Relatively few members: - all other things equal, a cartel will be more successful controlling the production and price if it has a smaller number of producers. It is generally easier to come to an agreement, the consequences of cheating are greater (i.e. one firm s cheating has a larger impact on market price when the firms are big) and it s easier to figure out who is cheating when there are only a small number of participants. Dominant producer all other things equal, a cartel will be more successful controlling the production and price if it has one large producer. That large producer is the natural leader of the cartel and can exert influence on the other members. If the dominant producer threatens to forego the production quota, it will often hurt the other members more than it would itself, which is a negotiation weapon. Similar production costs: Each producer in a cartel will want to set price at the point that maximizes its own profit. A low cost producer will find it most profitable to produce a higher level of output than a high cost producer, and a low cost producer will be reluctant to maintain the large production cuts necessary to keep the price anywhere near

20 79 the level a high cost producer would prefer. It will be difficult for them to agree on a target price in the first place and harder for them to maintain that target price. High and inelastic demand: A cartel will not be successful if the good it sells has a very low demand this is the main reason the lead cartel failed. The strategy of cartels is to cut production in order to boost price; this will only work if the buyers keep buying the product. If the good has elastic demand, then a rise in price will cause a larger drop in sales, in proportional terms. Total revenue follows quantity when demand is elastic. The good needs to be one that consumers have a high necessity for and few substitutes so that they will keep buying it at the higher price. When demand is inelastic, total revenue will follow price, which the cartel is raising. Cartels can be the victim of their own successes as they boost price higher and higher they encourage the entry of new producers into the market. As OPEC pushed the price of oil from several dollars a barrel to $35 dollars a barrel in less than ten years, a flood of oil exploration and new oil fields resulted. This reduced OPEC s clout during the 1980s and 1990s. The cartel can be thought of as operating in a gray area between the oligopoly and monopoly market structures. It is a market with a few large producers which fits the oligopoly profile; however, it is trying to operate as a single producer which fits the monopoly profile. The more cohesive the cartel the more the market will behave as a monopoly. Most cartels, however, struggle to coordinate the disparate needs of the individual members, and in general, behave as oligopolies. Another case that falls between the two market structures is the oligopoly market with one huge dominate producer. There comes a point where the dominating firm can be thought of as having achieved virtual monopoly status even though it has not eliminated all vestiges of competition. Both AT&T and Microsoft reached near 90% market share or beyond, in industries that had no other major producers; as this occurred we have shifted them into the monopoly market structure. Journal Topics: Complete the following assignment: Use the Commerce Department handout and find 2 examples each of: monopolistic competitive weak oligopoly standard oligopoly strong oligopoly case where the HHI indicates a highly concentrated market and the concentration ratio does not. Find and summarize a web site on cartels or game theory. Minimum of one page