Chapter 11: Price-Searcher Markets with High Entry Barriers

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1 Chapter 11: Price-Searcher Markets with High Entry Barriers I. Why are entry barriers sometimes high? A. Economies of Scale in some markets average total costs fall over the full range of output. Therefore the larger incumbent firms always have lower costs. It is then difficult for new firms to enter the market and compete with the low cost firm. B. Government Licensing these are legal barriers to market entry. In Licensing the government makes potential firms obtain permission from the government in order to perform business in the market. C. Patents a patent grants the founder of a new design with the property right to exclusive use of their inventions. 1. The US patent has a length of 17 years. 2. Another firm/person can duplicate the invention without the permission of the patent holder. 3. Why do you think oil companies buy up patents on new electric and solar cars? 4. The down side, is that during the patent period, consumer typical face high costs. However, patents serve as an incentive for inventors to create new inventions.. Control over Essential Resources if a firm has control over the resources for an industry, they can block entry into the market. Example ALCOA controlled the bauxite supplies that prevented firms from producing aluminum. II. The Case of Monopoly A. Monopoly 1. Monopoly is a market with a. High Entry barriers b. A single seller of a well-defined product for which there are no good substitutes. 2. There are only a few real world examples. B. Price and Output Monopoly 1. The market demand curve is the monopolist s demand. 2. Just like all other markets that we have looked at, the monopolist will expand output until marginal revenue equals marginal cost. 3. This profit-maximizing output rate can be sold at a price indicated on the firm s demand curve. 4. Graphical picture of the market below 5. Numerical example on page 287.

2 Price Profit MC P ATC C Q Quantity C. Profits Under Monopoly 1. High barriers to entry insulate the monopolist from direct competition with rival firms producing a similar product. 2. In markets with high entry barriers, monopoly profits will not attract rivals who would expand supply, cut prices, and eliminate profits. 3. However, sometimes demand and supply conditions can exists such that the monopolist can t earn a profit. Price ATC C MC P Loss Q Quantity

3 . The Monopoly Model and ecision Making in the Real World 1. In the real world, the monopolist cannot see the actual demand curves that they face. 2. Thus, we can think of the monopolists as maximizing profits by measuring their expected revenues and costs. 3. Thus, we can think of the monopolists as acting as if the MC= rule was used. III. Characteristics of Oligopoly A. Characteristics 1. Small number of firms these few firms control the entire market supply, competition among the few firms. 2. Interdependence among Oligopolistic Firms because the number of firms is so small, any decisions made by one of the firms will affect the demand, price, and profits of the rival firms. 3. Substantial economies of Scale large-scale production is typically needed to minimize costs 4. Significant Barriers to Entry just as with monopolies, barriers to entry limit the ability of new firms to compete with existing firms. 5. Products may be Either Identical or ifferentiated a. When the firms produce identical goods there is less opportunity for non-price competition b. When differentiated goods are produced, the firms can use style, quality and advertising as competitive weapons. IV. Price and Output in the Case of Oligopoly A. There is no general theory for the price and output under an oligopoly market. 1. If all of the firms operate independently of each other, the competition would drive the price down to production costs, zero profit. 2. If the firms all collude together, they drive the price up to the monopoly price. 3. Usually the result is somewhere in between. 4. Graphically

4 Price Pm Pc Qm Price and Output when the firms collude Qc Price and Output when the firms compete LRATC B. Incentives to Collude 1. Oligopolists have a strong incentive to collude and raise their prices. 2. Each firm also as an incentive to cheat on the collusion by lowering the price because the demand curve faced by each individual firm is more elastic than the market demand curve. 3. This incentive makes collusive agreements hard to maintain. Quantity Pi Pf Qi qf 4. Notice that the firm, would prefer the price Pf instead of Pi, because at Pi they would have no demand, and therefore no sales C. Obstacles to collusion 1. As the number of firms increases, the likelihood of maintaining an effective collusion becomes smaller. It only takes one firm to break the collusion.

5 2. When it is difficult to detect and eliminate price cuts, collusion becomes less attractive. 3. Low barriers to entry are obstacles to collusion. The current firms fear the entry of a new firm that could break up the collusion. 4. Unstable demand conditions lead to unstable collusion. Can lead to different opinions between firms, which could lead to the collapse of collusion. 5. Vigorous antitrust action increases the cost of collusion. Higher threat of being caught, and the fines involved with being caught. V. Market Power and Profit: The Early Bird Catches the Worm A. Market Power and Profit 1. Basic idea: buying stock in an established oligopoly firm, does not guarantee making money, you could be too late 2. The incumbent firm has already established themselves and their level of profit. 3. The best way to make money is to buy into a new oligopoly market. 4. Example: although you would still make some money by buying Microsoft stock, you could have made much more if you would have bought it early. VI. efects of Markets with High Entry Barriers A. Reduction in the competition between the firms in this market will limit the options available to the consumers. B. Reduced competition leads to Allocative inefficiency, too limit product is produced. C. When entry barriers are high, consumers are less able to direct producers to serve their interests.. Government grants of monopoly power will encourage rent seeking behavior. Firms will waste excess amounts of resources in an attempt to secure government grants of protected production. This will enable the protected firm to maintain market power. VII. Policy Alternatives When Entry Barriers Are High A. Natural Monopoly A natural monopoly exists when long-run average costs continue to decline as firm size increases, over the entire market demand. B. Policy Alternatives to control Oligopolies. 1. Antitrust Policy and Controlling the structure of the industry.

6 a. This policy usually involves maintaining or increasing the number of firms in an industry to keep the market power of individual firms low. b. This policy should not be used in an industry that involves a natural monopoly the policy could lead to higher costs, and the new firm would seek ways of merging into a larger firm. 2. Reduce Artificial Barriers to Trade a. The government could reduce of eliminate tariffs, quotas, licensing requirements the limit entry into a market. 3. Regulate the Protected Producer a. The government can regulate the price or costs of a monopoly in hopes of reducing Allocative inefficiency. 1. Average Cost Pricing Fix the price at the level where average cost intersects the market demand. Since the monopolists cannot charge a higher price than the set level. The only way to increase revenue is to expand output. Therefore the final result is a lower price and more output. Allocative inefficiency has been reduced. 2. Marginal Cost Pricing Fix the price at the level where Marginal costs intersects the Market demand. Monopolists do not like this because in would generate a loss. Therefore this Pricing scheme is hard to maintain. 4. Supply the Market with Government Production use a government firm instead of a private monopoly. C. Problems with Regulation 1. Lack of information The government does not really know what the firm s cost and demand curves look like, therefore they are using their best judgment when setting a price ceiling. 2. Cost Shifting Managers in a regulated firm have more incentive to pursue personal objectives rather than lower costs. This is because the regulated firm is essentially guaranteed a fixed rate of profit. 3. Special-Interest Influence Firms lobbying for particular regulations over others. Example, the satellite dish companies will seek regulations which will limit their competitors such as cable companies from effective competition with satellite TV. 4. Government Production has little incentive for cost minimization and consumer satisfaction. What ever they do, they will stay in business.. Putting it all Together 1. Government intervention does not always lead to an attractive outcome, when ever possible, the reduction of artificial barriers is the most attractive alternative.

7 VIII. The Competitive Process in the Real World A. Competitive forces are even present in markets with high entry barriers high barriers do not prevent all potential firms from entering the market. B. Also there are other ways to influence an industry with out entering it, the profits and high price of the high barrier market, encourage technological change and the development of substitute products. Example WEBTV in the desktop market. C. All the firms always face quality competition from their rival firms.

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