Competition

First, the Economist’s View

Market Structure ContinuumPerfect Competition Monopoly

Monopolistic Competition Oligopoly

KinkedDemand

Many BuyersMany Sellers One Seller

Homogeneous Product

Unique Product

Few Sellers

Some Differentiation

Free Entry & Exit

Strong Barriers

Some Barriers

Perfect Information

Price Taker Price Searcher

LR Π = 0 LR Π > 0

Impersonal Competition

Personal Competition

My Market

Small Sellers Large SellerLarge Sellers

Perfect Competition1.Many Small Buyers2.Many Small Sellers3.Homogeneous product

RESULT

4.No Barriers to Entry

5.Perfect Information

• No market power on the buying side• Many alternative vendors• No product loyalty (very elastic)

EXTREMELY ELASTIC DEMANDPrice Taker (takes price as given)

• Profits will induce entry• Losses will induce exit• Zero economic profit in Long Run

• No mis-steaks (oops, no mistakes)

IMPLICATION: Firm & Market have different elasticities.

Separate Firm and Market graphs needed

Firm

• Firm (assumed to be one plant for simplicity)

• Cost curves

• Profit maximizes at Q where– Marginal Revenue = Marginal Cost

• Given Price (assumed fixed), sets Quantity

• Determines profit and whether to produce

Industry

• Collection of individual buyers determine Demand• Collection of firm decisions determines Supply• Equilibrium price set where

Quantity demanded = Quantity Supplied

• Total Equilibrium Quantity set• For Competition, Firm assumes market results

as given • Need

– One graph for industry (to set market price) and – One graph for firm (to set quantity for typical firm)

The Role of Price • Rationing –

– chase low-valued-use customers away– Allocate (scarce) resources to “best” use

• Allocation -– Move resources from surplus markets to shortage

markets

• Result:

The Invisible HandIndependent Individual Actions in Response to Incentives

– Resources used where most valuable– By those valuing the use the most

Market and Firm :Competitive Industry/Market

Long Run Equilibrium

P

Q

D

S

P1

Q1

P

Qfirm

ATC

MC

MarketFirm

P=Dfirm=MRfirm

Q1 firm

TFC

TVC

AVC

AFC

Competitive Firm with profit

P

Q

ATC

MC

P=Dfirm=MRfirm

Qfirm

MC = P => Qfirm

Profit (Π) = (P-ATC) x Q

Creates incentive for entry of new firms

π

AVC

TVC

TFC

Competitive Firm with a Loss

P

Q

ATC

MC

P=Dfirm=MRfirm

Qfirm

MC = P => Qfirm

Profit (Π) = (P-ATC) x Q < 0

Creates incentive for exit of new firms

Π(negative)

TVCTFC

AVC

Contribution to Overhead

Competitive Market and Firm:Effect of a Demand Increase

P

Q

D1

S1

P1

Q1

P

Qfirm

ATC

MC

MarketFirm

P1=Dfirm=MRfirm

Q1 firm

D2

P2=D=MR

P2

Q2 firm

Q2

D increase

Industry P and Q increaseFirm’s Demand (P) Rises

MC = P2 => Qfirm risesProfit (Π) = (P-ATC) x Q risesCreates incentive for entry of new firms

π

S2

Entry occurs until Long Run is re-attained. Π=0

Q3

TVC

TFC

Competitive Market and Firm:Effect of a Demand Decrease

P

Q

D1

S1

P1

Q1

P

Qfirm

ATC

MC

MarketFirm

P=Dfirm=MRfirm

Q1 firm

D2

P2P2

Q2 firm

Q2

Π(negative)

D decrease

Industry P and Q decrease

Firm’s Demand (P) Falls

MC = P2 => Qfirm falls

Profit (Π) = (P-ATC) x Q falls (< 0)

Creates incentive for exit of firms

S2

Q3

TVC

TFC

Market Adjustments

• Short Run– Industry price adjusted to get Qs = QD

– Firms raise or lower Q to equalize MC = P– Profits or Losses are earned

• Long run– Firms respond to Profits (enter) or losses (exit)– Price adjusts to change in supply– Firms adjust to new price– Eventually π = 0 and entry or exit stops

Competition Implications

• Long Run Profits are zero – Due to entry and exit

• Maximum surplus (producer + consumer)

• Price serves as signal for resource allocation

• Presumed when “invisible hand” invoked

• May not give “best” distribution or output– Public goods, externalities, equity

Inter-industry Adjustments

• Profits draw firms into industries decreasing profits for firms already in industry

• Losses drive firms out increasing profits for those remaining

• Relative profitability may attract firms from one industry to another– Toys-r-us (according to Jay Leno) says it may sell its

toy business (??)

• Risk differences (etc.) may leave some differences in profitability across industry

Efficiency

(Presumes Competitive Market)

Efficiency

• Cannot help one without hurting another– If Marginal benefit > Marginal cost,

• increase output

– If Marginal benefit < Marginal cost, • decrease output

– Efficiency<=>Marginal Benefit=Marginal Cost• In markets happens at D,S intersection

• Efficiency is most output, given input

• Equity is “fairness”

Why and How Efficiency?

• Why?– Maximum surplus– Buyers and Sellers satisfied

• Why is market equilibrium best?• The following affect output => efficiency down

– Price ceilings– Price floors– Taxes and Subsidies– Monopoly– External benefits and costs (effects on others: e.g.,

pollution)• Price vs non-price allocation

Efficiency, graphically

P

Q

D

S

P1

Q1

Producer Surplus

Consumer Surplus

Benefit for which the consumer does not pay.

Revenue without associated opportunity cost.

Effect of a Tax on Efficiency

P

Q

D

S

P2

Q2

Consumer Surplus

Producer Surplus

Deadweight Loss

Tax Revenue

S + tax

P2+tx

This is called dead weight loss because these (not produced) units are more valuable than their cost. That is, lost benefit without saved cost.

Tax

Q1

P1 Notice price consumer pays goes up (P1 to P2 + tax)

Notice price supplier receives goes down (P1 to P2)

Monopoly

The Firm as Market

Monopoly1. Many Small Buyers2. One Seller3. “Unique” product

RESULT

4. Barriers to Entry

5. Perfect Information

• No market power on the buying side• No alternative vendors• No close substitutes

LESS ELASTIC DEMANDPrice Setter (must choose price)

• Profits will not induce entry• Losses will not induce exit

• No mis-steaks (oops, no mistakes)

IMPLICATION: FIRM IS MARKET (one graph)

Monopoly decision process

• Profit maximization– Marginal Cost = Marginal Revenue– Recognize effect of price on quantity demanded– MC = MR < P (society’s value of product)

• Sources of Monopoly Power– Control of resources– Government intervention – Economies of Scale– Network economies (first mover, setting the standard)

Decision Process• How Much?

– MC = MR => Q*

– Given Q*: • P set on demand curve at Q*

• Ave. Total Cost determined from ATC at Q*

• Ave. Var. Cost determined from AVC at Q*

• Ave. Fixed Cost = ATC – AVC at Q*

• Whether?– If Price > Ave. Var. Cost at Q*, net cash flow +

• So produce—better off producing than not

• MR = ΔTR/ΔQ =revenue change per unit added

Net change in revenue is blue box minus yellowΔTR= P x ΔQ (+) + Q x ΔP (-)MR = {20 x (40-20) + 20 x (20-30)}/(40-20) = 10<20 = {40 x 20 – 30 x 20}/20 = 10

Marginal Revenue for Monopoly

Pric

e

Quantity

20

40

30

20

Revenue at higher price

Revenue at lower price

Revenue received at either price

(-)

(+)MR D

Profit Maximization for Monopolistic firmMonopoly

P

Q

DMR

Qfirm

P1

MC

ATCAVC

TVC

TFC

πATC1

AVC1

Qfirm based on MR = MC

P1 => max, given Qfirm

ATC1, given Qfirm

AVC1, given Qfirm

TVC = AVC1 x Qfirm

TFC = (ATC1 - AVC1) x Qfirm

π (profit)= (P1 – ATC1) x Qfirm

Notice: Q set using only marginals

Because of barriers to entry, these profits can persist.

TR

TR = P1 x Qfirm

Contribution Margin

P

Q

MC

ATC

AVC

Monopoly with a Profit

DMR

P1

Qfirm

ATC1

π

TFC

TVC

TC=TFC+TVC

TR = P x Q

Π = TR – TC = TR – TVC - TFC

P

Q

MC

ATC

AVC

Monopoly with a Loss

Still wanting to Produce

DMR

P1

Qfirm

ATC1

Π < 0

TFC

TVC

Contribution to overhead.

P

Q

MC

ATC

AVC

Monopoly with a Loss

Wanting to Shut Down

DMR

P1

Qfirm

ATC1

Π < 0TFC

TVC

Negative Contribution to overhead.AVC1

Effect of Monopoly on Efficiency

Monopoly

P

Q

DMR

Qfirm

P1

MC

Qfirm based on MR = MC

P1 => max, given Qfirm

Notice: P and Q set using only marginals

P1 is value of last unit sold

MC @ Qfirm is the cost of the last unit sold.

P>MC @ Qfirm so society loses this surplus

As long as P>MC, surplus exists

Lost surplus is the triangle

Dead Weight Loss

Notice that Setting P=MC (competitive result) will cause no lost surplus

Natural Monopoly

P

Q

LAC

D

LMC

MR

PMon

Qfirm

ATC1

πMon The key issue is the size of the firm relative to the market.

Economies of Scale are significant

Demand is such that only one firm has room to be profitable.

Profits would occur without regulation

Profits would attract entry => both firms would lose money

Rate regulations gives exclusive right to one firm, keeps price down,

Preg

πReg

QReg

& assures πIncreases Q,

Price Discrimination

• Separable Markets– Otherwise, people will buy in one market and well in

the other.

• Different Elasticities– Otherwise, there is no advantage to price

discrimination

• Raise price in inelastic (P insensitive) market• Lower price in elastic (P sensitive) market• Until MR is the same in each

Price Discrimination: Movies

P

Q

P

Q

Adults Kids

DMR

DMR

Assume constant Marginal Cost for simplicity.

MC

Find Qfirm as we always do => MC = MR for each section of market

QAdultsQKids

Set Price based upon Qfirm and the relevant demand curves.

PAdults

PKids

Notice: PAdults > PKids because adult Demand less elastic

Kids are distinguishable

Demand more elastic

Lower maximum price

Construct MR (MR <P) for each segment in same way as monopoly

Competition

The Practical Aspects

Competition Basics

• Know your competitors (knowledge)

• Selectively communicate

• Preannounce price increases

• SHOW willingness to defend

• Educate competitors (not worth price war)

When to Compete

• Cost competitive advantage

• Niche (claim the whole niche)

• Complementary products

• VERY Elastic market

To React or not to React• Think Long Term

• Is there a better response than price?– If not:

• Focus on @ risk customers• Focus on incremental value• Focus on competitor’s high margin area• Raise cost to competitor (educate his/her cust.)

– Second round?– Is it worth it?– Mk Share worth Saving?