ECO101 PRINCIPLES OF MICROECONOMICS Notes. Oligopoly and Pricing Practices

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1 ECO101 PRINCIPLES OF MICROECONOMICS Notes Oligopoly and Pricing Practices Overview In Chapter 8 we examined how firms determine at what price and what output level to produce in order to maximize profits under conditions of either perfect competition or monopoly the two extreme cases of market structures. We concluded that irrespective of the market structure profit is maximized at an output level where = MC, even though the specific price and output level were different for each firm (depending on their costs) as well as between monopolists and perfectly competitive firms. In this chapter we consider the decisions of firms regarding price and output when markets are imperfectly competitive (oligopoly and monopolistic competition). We will see in this chapter that the concepts of defensive and aggressive strategies, pricing tactics and price wars, inter-dependence between competitors actions, formation of cartels and collusion, uncertainties and business games, all become a lot more relevant than in perfect competition and monopoly cases. Of course, by referring to oligopoly and monopolistic competition generally as imperfect competition, we don t mean that these market structures are less important relative to perfect competition and/or monopoly. On the contrary, the majority of real life firms in modern economies actually fall under the loose categories of monopolistic competition or oligopoly. The curricula (theory and case studies) taught in most business schools/programs actually characterize the operations, strategies, marketing tactics, product promotion and advertising, etc of firms under these market conditions, rather than those of perfect competition and monopoly. Overview of Market Characteristics We reproduce below the table we constructed at the beginning of Chapter 8, which reviews the basic characteristics of the various market structures with respect to number of sellers, control on prices, barriers to entry, etc: Com parative Characteristics of M arkets Perfect C o m p e titio n M onopolistic C o m p e titio n O ligopoly M onopoly N u m b e r & N a tu r e o f S e lle rs M a n y (s m a ll s e lle rs ) Independent No control M a n y (s m a ll to m edium ) Som e control Few (large) Inter-dependent Considerable control O n e Absolute control N a tu r e o f Product Hom ogeneous (no d iffe re n tia tio n ) Som e d iffe re n tia tio n S o m e tim e s b u t not alw ays N o s u b s titu te s B a rrie rs to entry N o n e Low Considerable Entry is blocked Profit Potential Product Prom otion & A d v e rtis in g N o rm a l P ro fits in LR None or m inim al S o m e p ro fits in SR & LR C o n s id e r a b le Considerable Profits in SR & LR H e a v y Large Profits in S R & L R Som e but not directed to com petition, but to increase sales 1

2 Product Differentiation MONOPOLISTIC COMPETITION The key distinguishing characteristic of monopolistically competitive firms is product differentiation. Firms compete among themselves by trying to differentiate themselves from the competition. Differentiation may be at the level of the product, or at the level of differentiating the entire company. This may take the form of promotion, advertising, design, product features etc. This differentiation may be real (features, quality, etc) or perceived by consumers through smart advertising giving the impression of differentiation. Because products are differentiated, it is difficult to speak of an industry of similar products (as we did for perfect competition and monopoly). For this reason the analysis focuses on the behaviour of individual firms. Monopolistic competition is common in service industries: clothes, shoes, restaurants, cafes, entertainment, etc. For example, McDonalds competes with KFC, Pizza Hut competes with Toronto Pizza, the many restaurants lined up in Ayia Napa, each with its distinct kind of food it offers, its character, design, etc. Each café or club or pub in Nicosia, for example, will have something different to offer in order to attract customers. For some it would be the atmosphere, for others it would be the location, for yet others it would be the quality of service. Bars, for example, even though they compete on price, they also vary greatly in the added benefits they offer in terms of music, style and ambiance. Reviewing the table above with the comparative characteristics of market structures, we see that under monopolistic competition we see that the number of sellers is fairly large hence the competition portion of the name of this market structure and products are differentiated which differentiates each firm from its competitors and thus affords each firm some monopolistic power and some control on price hence the monopolistic portion of the name. The Profit Maximization Rule Revisited The theoretical framework for the operations of firms in a monopolistic competitive market is similar to the model of profit maximization developed in the framework of Monopoly in Chapter 8. In the case of monopolistic competition, however, because of the large number of sellers and the fact the barriers to entry are not very high, the entrance of more firms cuts the market share of each existing firm as they all compete against each other for a share of the consumers wallet. Yet, each firm, being small and differentiated (location, etc), basically does not worry much how rivals will react to their actions (say, in the case of a price change). In a sense each firm acts independently from each other. Therefore, a firm in a monopolistically competitive environment is faced with a more elastic demand than the monopolist. Additionally, as in the case of the monopolist, price (or AR) exceeds marginal revenue. As seen in the graph below, the firm will maximize its profits where = MC. As drawn in the graph the firm is making profits, as represented by the shaded area the difference between P (or AR) and ATC multiplied by the number of units sold. In the event that the firm is making losses, however, it will consider whether to stay in business in the short run by calculating the firm s profit contribution, that is, by seeing whether the price (or AR) is sufficient to cover the firm s average variable costs (AVC). As in the cases of monopoly and perfect competition, if P >AVC then it pays for the firm to stay in business in the short run since it is recovering part of its fixed costs (overheads). If, on the other hand, P < AVC, the firm should close down. P* Short Run Profits MC ATC Long Run MC P* ATC D = AR D = AR 2

3 As seen from the model of profit maximization in the left panel of the graph above, in the short run the firm in monopolistic competition behaves in similar way as a monopolist. In the long run, however, the existence of short run economic profits encourages and attracts new entrants and competition intensifies. In Cyprus, for example, look at what happens over time in the opening of new businesses because of the short run profit potential: the bakeries and the convenience stores (periptera) that are springing up in every corner, the cafes, pubs and clubs, and the theme restaurants (fast-food and luxury ones) opening up at a fast pace all over Nicosia, the many restaurants, clubs, bars and souvenir shops in all the streets of Ayia Napa, Protaras, Paphos and the other tourist sea side towns of Cyprus, the booking and lottery shops, and many other. As a result of increased competition, each firm s demand curve shifts to the left (reflecting the decreased demand and market share of each). With more competition, prices come under pressure to fall. With costs remaining the same, firms end up in tangency equilibrium (the ATC curve is tangent to the AR curve), which means that the firms make zero economic profits. Remember that the ATC includes the firm s full opportunity cost (including a normal rate of return for the owners). This long run equilibrium of firms in monopolistic competition is shown in the right panel of the graph above. Market Efficiency and Excess Capacity If you recall from our discussion of long run equilibrium of perfect competition, we determined that firms, and by extension the entire market, were in equilibrium in the long run at the lowest point of their long run average cost curve. This is the point of maximum economic efficiency. In the case of firms operating in monopolistically competitive markets we have seen above that the firms reach long run equilibrium at the downward portion of its long rum average cost, which means that they are not using efficiently all their production capacity. In other words, each firm has a production set-up (capacity) that can produce X amount of goods or services, but because of competition and new entrants, each is producing less than their capacity. This is evident, for example, on an average day if you go down town in Nicosia you will find many restaurants and cafes that have many empty seats. The same is true for instance for many bakeries which at the end of the day have a lot of unsold bread. Therefore, these firms have excess capacity. In the graph below we compare long run equilibrium of the firm in perfect competition and monopolistic competition, and represent excess capacity as the difference between what the firm has the capacity to produce (Q C ) and the actual profit maximizing output Q*: LR Equilibrium in Perfect Competition MC LR ATC LR P* D=AR=P LR Equilibrium in Monopolistic Competition MC P* ATC D = AR Q* Q C Quantity Excess Capacity OLIGOPOLY As the name implies and seen in the table at the beginning of this chapter, the number of firms in this type of industry is few, firms have considerable control on prices and actively engage in non-price competition: promotion, advertising, etc. Additionally, in order to keep competition out, there are considerable obstacles (barriers) to entry. The brief analysis of the key barriers to entry discussed in Chapter 8 in the context of Monopoly are equally valid and relevant for oligopoly. The difference is that in oligopoly the degree or height of the barrier or obstacle may not be absolute as in monopoly. We reproduce below this analysis about barriers for convenience: 3

4 Barriers to Entry Economies of Scale: In some situations, in order to be economical (efficient) to produce a good or service, the scale of operation must be very large to cover the entire market. This is especially true for small markets. In Cyprus, for example, besides the utilities companies (the Telecommunications Authority and the Electricity Authority), which control the whole market (natural monopolies) we have the cement companies (Cyprus Cement, Vassiliko), the aluminium companies (Muskita). Ownership / Control of Key Resources or Sales Outlets: Some companies may own or control the raw materials (such as mineral resources) for the production of certain goods, or control the wholesale or retail distribution outlets whereby goods are brought to the market and sold to consumers. Legal Protection: The firm may be protected from new competitors entering the market by patents (for new inventions), copyrights (for intellectual properties such as books, software programs, etc), licensing agreements (In Cyprus such licences exist for operating TV stations, Taxis, Z-cars, etc), or even tariffs and barriers imposed by governments to protect local producers. Substantial Capital Outlay Requirements: For certain goods / activities to be offered (for example the establishment of a car manufacturing company such as Ford or Mercedes-Benz, a steel producing company such as US Steel, an airplane manufacturer such as Airbus or Boeing, etc), they require a very large investment to built. Other examples would be Telephone companies, which need to install the necessary equipment and all the cabling to provide service to homes and businesses. It is clear then that the size of the initial investment is an obstacle to entry. Brand Loyalty: In some situations, firms are able to develop such a strong customer loyalty for their brand that it becomes very difficult for newcomers to compete on the same terms. In some instance the name of the product becomes synonymous with the activity/service the product provides. Examples would be: Xerox (for photocopying), Hoover (for vacuum cleaning), Coke (for the soft drinks). Of course, other very strong brands exist: McDonalds, Pepsi, Sony, Nokia, Gillette, Minolta, BMW, Citibank, Hilton, etc. Critical element for products to gain brand loyalty is the consistency of quality over time. The above barriers are not easy to overcome by firms wishing to break into a market. The only exception would be legal barriers, which over time may be removed. For example, trade barriers (tariffs and quotas) are eliminated through trade or customs union agreements (European Union, North American Free Trade Association) or through global negotiations in the framework of the World Trade Organization (WTO) involving all nations. Additionally, licensing agreements may be relaxed to promote competition, and some copyrights and patents may sometimes become ineffective because of pirate products or development of near-similar (generic) products, especially in IT (telecommunications) and pharmaceuticals. Globalization The revolution in information technology, the liberalization in the movement of factors of production (labor and capital) and globalization (multinational companies) are bringing dramatic changes in the way modern corporations conduct their business. To an extent also these change drivers (globalization and the prevalence of multinationals) are reducing the importance of the above trade barriers. Many of the wellknown multinational companies (Coca Cola, Pepsi, Gillette, Unilever, Proctor & Gable as well as many companies in the services industry) managed to achieve scale economies in production without having a large market share at home by achieving entry in many foreign markets and thus selling globally. The recent opposition and demonstrations in many countries against globalization goes to the heart of the issue, because local small and medium size companies and workers feel threatened by these multinational companies because they believe that gradually they will drive the less efficient (higher cost-producing) domestic firms out of business. Inter-dependent Actions and Strategies We have seen above that firms under monopolistic competition used product differentiation to compete, but because of their relatively small size, each acted independently from the rest. By contrast, in oligopoly the most striking characteristic, given that the number of firms is small, is that of interdependence. This means that before making a decision (for example, to change prices) each firm must first consider what the reaction of its rivals might be. Often firms enter into a frame of mental action reaction whereby they try to outguess what the other would do. This resembles a game of chess! In fact, economists developed a whole body of theory called Game Theory in order to explain these strategic-tactical behaviors of firms in oligopolistic market. It is in this sense that we characterize the behaviour of oligopolists as interdependent. 4

5 Because of the many uncertainties about rival behaviour, many firms in oligopoly are faced with a series of strategic considerations and dilemmas: should they compete head on with the rival firms by undercutting each other in prices, or should they get together and agree to fix prices (in other words, to form a cartel)? Most of you will have certainly seen price wars breaking out between carmakers, newspapers, fast food restaurants ( the burger war ), or have witnessed the battles between large super market chains (in Cyprus, the price war between Orphanides and Chris Cash & Cary). Through time, economists have developed several models in order to explain the different types of behavior that one finds in oligopolistic markets. There is no single unifying ( neat ) theory as are the theories of perfect competition and monopoly. There are two broad groups of models: the traditional models and the game theory models. In this chapter we will discuss only the traditional models. One such model is the kinked demand curve one, which we discuss briefly below. The Kinked Demand Curve This model is based on the action reaction considerations of oligopoly firms, based on the traditional economic firm behaviour. As we will see at the end, this model is an attempt to explain the empirical observation that over long periods of time, there is relative price stability; in other words, firms do not engage in price competition, but rather engage in non-price competition (with heavy advertising and promotion campaigns). Let s consider below how a firm may perceive its demand curve under oligopoly. The firm observes the current price and output levels, but must try to anticipate rival reactions to any price change. First consider the case that the company is contemplating to reduce its prices. How would rival firms react/respond? At the risk of losing sales, it is logical to expect that rivals will not sit idle, but rather rush to reduce their prices as well so as to maintain their market share. So the impact on sales from the price reduction will be zero or at best small. So, in the case of a price reduction demand is likely to be relatively inelastic. So below the original price P* the demand curve will be steep. If we now consider the case of a price increase, we would expect that rivals are less likely to react. Since their product is now relatively less expensive, and therefore more competitive, they stand to attract more business. Therefore, for price increases above the original market price P*, demand would be relatively elastic. If we put these two reaction scenarios together in the same graph (as represented by two demand curves, one more elastic for price increases and the other less elastic for price declines), we have a situation where at the original market price of P* the demand curve has a kink. The firm perceives that it faces a kinked demand curve. This is shown in the graph below. Notice also that this peculiar-looking demand curve (which effectively it is a combination of two different demand curves) produces a marginal revenue () curve that has a discontinuity (a break) below the kink. We also see in the graph below that if different marginal cost curves intersect the marginal revenue curve at any point on its discontinuity, then the firm will still maximize profits at the same price and output level, that is, at P* and Q*. Kink P* MC 3 MC 2 MC 1 Demand 5

6 In economic terms, given the perception by a firm of the action reaction described above, the firm expects that its revenues will be reduced whether prices fall or rise. Therefore the best strategy is to keep prices unchanged (stable) at P*. This observation helps explain the empirical finding that frequently over time prices are stable. That is, it is observed that individual firms do not always adjust prices when costs change, even in the face of increases in marginal costs. It should be noted that assumption of price stability does not hold when costs increase throughout the whole industry such as through successful wage bargaining or government imposed taxes on the industries product. One of the weaknesses of the kinked demand curve model is that it does not provide a theoretical justification or mechanism to explain how P* is determined in the first place. Cartels Collusive Oligopoly Collusion: This is an explicit (written) or implicit (assumed) agreement between a small number of oligopolistic firms to limit competition, usually by fixing prices or by fixing the output of the industry. By joining their forces, oligopolists are able to behave as monopolists, having absolute control on the market. Such agreements are called cartels. Cartels may be overt (agreements known to the public) or covert (secret agreements). In most developed economies today cartels are illegal, but in some less developed countries there are no laws prohibiting their existence. In Cyprus, the law (which is now harmonized with EU law) explicitly forbids the operation of cartels. Yet there are instances where collusion is practiced secretly. The best-known cartel in the world is OPEC (the Organization of Petroleum Exporting Countries) which controls the oil market by limiting production, thus creating technical shortages forcing the prices of oil higher. OPEC is responsible for the quadrupling of oil prices in the mid-1970s and the increase in oil prices in 2003 around (and periodically above) $30. In order for collusion to be possible, there must be only a small number of producers collusion is not possible in perfect competition where the number of sellers is large. Yet, one of the characteristics of cartels is that once they are in place, there is a tendency on the part of participants to cheat in other words, to produce a higher output (or even undercut prices) in order to increase their revenues. Therefore, often cartels fall apart. Contestable Markets The final area considered in this chapter is that of contestable markets, a theory gaining more relevance and coverage in economics due to globalization. A contestable market is one where a fairly large number of firms operate, and where entry and exit is relatively easy (free). Therefore, some of the key characteristics of prefect competition are present. Yet, it doesn t mean that all firms have the same size. The market may have a small number of relatively large players possessing some control on the existing market, but a large number of smaller players are present that provide a balance in the power of the large ones and their behavior cannot go unnoticed. In addition, new comers may enter the market if they see opportunities for profit. For instance, due to the intensifying globalization, the number of potential entrants increases and defined markets (like domestic markets) become more vulnerable. Examples of contestable markets are the airline routes between various destinations which are becoming more liberalized. For instance the route Larnaca-Athens was up to now controlled by Cyprus Airways. Now, however, this route (and many others) are open to more operators (such as chartered or low-cost airlines) which can decide whenever they feel it is to their benefit (and for the time period they decide) to add these routes to their schedule. As easy as they can enter a market, competitors can exit, when the profit opportunities are no longer present. Strategic Entry Deterrents: Of course, some of the larger players in these markets always try to find ways to deter (stop) new comers entering their market they behave in other words like oligopolists. For instance, the detergent/soap market, or the personal care market may be considered as contestable markets, because new comers may easily enter a market without difficulty (regulations, capital requirements, etc are low). One way that large players in a market (the likes of Gillette, Proctor and Gamble, Unilever and others) try to protect their market shares is by having a wide range of brands the many brands of soaps/detergents produced by Unilever, the many brands of toothpastes and other personal care products by Proctor and Gamble, and Gillette, the many different models of athletic shoes produced by Nike and Adidas, etc). Thus, these companies believe that the wider the range of brands they produce, the less likely a rival will be successful in breaking into their market. 6

7 References for further reading: Bade, R. and Parkin, (2007). Foundations of Economics 3 rd edition (Pearson Education). Begg, D., Fischer, S. and Dornbusch, R. (2005). Economics 8 th edition (McGraw-Hill). Mankiew N. Gregory (2007). Principles of Economics 4 th edition (Thomson, South-Western). McConnel C. and S. Brue (2005). Economics 16 th edition (McGraw-Hill). Miller, R.L (2006). Economics Today 13 th edition (Pearson Addison Wesley). Sloman John (2006). Economics 6 th edition (Prentice Hall). 7