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Contents: 1.
Monopolies: Why they arise Production / pricing decisions Welfare cost Price discrimination Public Policy
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Monopolistic Competition: Product differentiation Advertising
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Oligopoly: Between Monopoly / Perfect Competition Markets with few Sellers Game Theory Public Policy
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A sk Ellie!
Got an Economics question tickling your pickle? Well Ellie O, your Economics Agony Aunt is here to help with all those complicated terms! ! Dear Economics Agony Aunt, I’m really struggling with the concept of Imperfect Competition. What is it? Do the conditions of perfect competition not always exist? Help!
David, Co. Carlow Hi David, Not to worry at all! It’s quite simple really. When assumptions of perfect competition do not exist, we say that firms are operating under imperfect competition. Imperfect competition exists when firms are able to differentiate their product in some way and so can have some influence over price. There are different degrees of imperfect competition. The opposite end of the spectrum is monopoly. Monopoly is a market structure with only one firm. However, in reality firms can exercise monopoly power by being the dominant firm in the market. Market share is the proportion of total sales in a market accounted for by a particular firm. A firm can exercise market power when it is in a position to raise the price of its product and retain some sales to its rivals. Hope that helps you David!
Economics Agony Aunt x
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!Dear Economics Agony Aunt, I badly need your help! Why do monopolies arise? I don’t understand!
Ciara, Co. Donegal Dear Ciara, Well firstly, a monopoly is a firm that is the sole seller of a product without close substitutes. The number one cause of monopolies is barriers to entry. A barrier to entry is anything that prevents a firm from entry a market or industry. The stronger the barrier to entry the more difficult it is for a firm to enter a market and the more market power a firm can exert. A monopoly can remain the only seller in its market because other firms cannot enter the market and compete with it. The easiest way for a monopoly to arise is for a single firm to own a key resource! In many cases, monopolies arise because the government has given one person or firm the exclusive right to sell some good or service. Sometimes the monopoly arises from the sheer political clout of the wouldbe monopolist. Similarly, when a novelist finishes a book he can copyright it. Also, a natural monopoly is when an industry can supply a good or service to an entire market at a lower cost can two or more firms. A natural monopoly arises when there are economies or scale over the relevant range or output, e.g. the distribution of water. Many of the largest firms in the world have grown partly through acquisition, merger or takeover of other firms. As they do, the industry becomes more concentrated; there are fewer firms in the industry. I hope that makes it easier for you Ciara.
Economics Agony Aunt x
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!Dear Economics Agony Aunt,
With regards to monopolies, how to they make production and pricing decisions? I’m very confused. Please help.
Lisa, Co. Cork Hi Lisa, The key difference between a competitive firm and a monopoly firm is the monopoly’s ability to influence the price of its output. Because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quality it supplies to the market. A monopoly’s revenue is its price of a good or service multiplied by the quantity and the marginal revenue would be the additional revenue a firm earns from selling one additional unit of output. Now, how does such a firm maximize profits?! Suppose, first the firm is producing at a low level of output when the marginal cost is less than the marginal revenue. If the firm increased production by 1 unit, the additional revenue would exceed the additional costs, and the profit would rise. Thus, when making marginal cost is less than marginal revenue, and the firm can increase profit by producing more units. A similar argument applies at high levels of output, when marginal cost is greater than marginal revenue. If the firm reduced production by one unit, the costs saved would exceed the revenue, the firm can raise profit by reducing production. In the end, then firm adjusts its level of production until the quantity reaches at which marginal revenue equals marginal cost. For competitive firms: P= MR=MC For monopoly firms: P > MR x MC And that’s how monopolies make production and pricing decision!
Economics Agony Aunt x
! Dear Economics Agony Aunt, I don’t understand—why does a monopoly not have a supply curve? Please help!
Owen, Co. Dublin Dear Owen, Good question! When analyzing the price in a monopoly market we use a market demand curve and the firm’s cost curves. What happened to the supply curve? A supply curve tells us the quantity that firms choose to supply at any given price. This concept makes sense when we are analyzing competitive firms, which are price takers. But a monopoly firm is a price maker, not a price taker. It is not meaningful to ask what a firm would produce at any price because the firm sets the price at the same time it chooses the quantity to supply. Indeed, the monopolist’s decision about how much to supply is impossible to separate from the demand curve it faces. The shape of the demand curve determines the shape of the marginal revenue curve, which in turn determines the monopolist’s profit- maximizing quantity. And that’s why a monopoly does not have a supply curve!
Economics Agony Aunt x !
!Dear!Economics!Agony!Aunt,! What!is!the!welfare!cost!of!monopoly?!Is!monopoly!a!good!way!to!organize! a!market?!What!do!you!think?! Saoirse,)Co.)Wicklow)
Hi Saoirse, A monopoly, in contrast to a competitive firm, charges a price over marginal cost. From the standpoint of consumers, this high price makes monopoly undesirable. However, the monopoly is earning profit from charging this high price. From the standpoint of the owners of the firm, the high price makes monopoly very desirable. It is possible that the benefits to the firm’s owners exceeds the costs imposed on the consumers, making monopoly desirable from the viewpoint of society as a whole, in my opinion.
Economics Agony Aunt x
The monopolist's profit: The area of the yellow box is the monopolist's profit.
Marginal cost pricing for natural monopolies:
Monopolistic competitors in the Short Run: These maximse profit by producing the quantity at where the marginal revenue equals marginal cost. Firm A makes a profit as the price is above average total cost. Firm B loses money because at this quantity, the price is less than the average total cost!
! Dear Economics Agony Aunt, What is deadweight loss and is there deadweight loss associated with monopoly? Could really use your help! Tim, Co. Wexford Hi Tim, Yes, there is deadweight loss associated with monopoly because the market outcome under monopoly is different to that under conditions of perfect competition. Total surplus equals the value of the good to consumer minus the costs of making the good incurred by the monopoly producer. Also, we can view the inefficiency of monopoly in terms of the monopolist’s price. Because the market demand curve describes a negative relationship between the price quantity of the good, a quantity that is inefficiently low is equivalent to a price that is inefficiently high. When a monopolist charges a price above marginal cost, some potential consumers value the good at more than its marginal cost but less than the monopolist’s price. These consumers do not end up buying the good because the value these consumers place on the good is greater than the cost of providing them: this results in inefficient. Thus, monopoly pricing prevents some mutually beneficial trades from taking place. The area of the deadweight loss triangle between the demand curve and the marginal cost curve equals the total surplus loss because of monopoly pricing. I hope that makes sense to you Tim!
Economics Agony Aunt x
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, Hi Dylan, I have to say first of all that I don’t think it is a social cost. A monopoly form does not earn a higher profit by virtue of its market power. According to the economic analysis of monopoly, the firm’s profit is not in itself necessarily a problem for society. Whenever a consumer pays an extra euro to a producer because of monopoly price, the consumer is worse off by a euro, and the producer is better off by the same amount. This transfer from the consumers of the good to the owners of the monopoly does not affect the markets total sum of the consumer and producer surplus.
Economics Agony Aunt x
A Monopolistic Competitor in the Long Run: In a monopolistically competitive market, if the firms are making profits, new firms will enter and the demand curves will shift to the left. If the firms are making loses, old firms will exit and the demand curves will shift to the right. A monopolistically competitive firm finds itself in the long-run equlirium as shown on the left. Here, price equals average total cost and the firm earns zero profit.
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Often, in business practises, a seller may have different prices for different customers, despite the fact they are buying the exact same good. In economics, this practise is called PRICE DISCRIMINATION. Price discrimination most often occurs in monopoly situations. The main reason why price discrimination does not occur in competitive markets is there are too many firms, and if one in particular tries to sell at a higher price, the customer can simply find another firm to buy from. The monopolistic firm must have a certain extent of power in the market before they can even consider carrying out the process of price discrimination.
Why do monopolists want to price discriminate? Why do they treat certain customers differently to others? Pretend for a minute that you are the CEO of a record label, responsible for dealing with different musicians and the music that they produce. One of your extremely popular and talented artists, has recently released a new album, and you have bought the exclusive rights to the record for a price of €1,000,000. As you are the CEO, the cost of producing the album was 0. Therefore, the profit you are going to make is: money made equals the sum paid out to buy the rights. As the CEO of the company, it is your responsibility to choose the price the album is going to sell for. As you paid such a high sum (1,000,000) for the rights of the album, it is going to be necessary to pick a suitable price for the album so that you still make a profit. When it comes to any good, whether it be CDs, books or DVDs, there will ALWAYS be two types of customers; the hard-core fans willing to pay a high sum to get their hands on a copy, and the customers not too keen on spending much, but who would still enjoy having a copy. Say, for example, the hard-core fans are willing to pay €25 for the album, and the ‘not so pushed’ fans are willing to pay maximum €10. If 100,000 hard-core fans are willing to pay the €25, that is equal to €2,500,000, which when subtracted from the cost of the rights, gives a profit of €1,500,000. On the other hand, if 300,000 not so pushed fans are willing to pay €10, a total of €1,500,000 is achieved. When subtracted from the cost of the rights, a profit of €500,000 is achieved. Obviously, as CEO and monopolist, you are going to be drawn towards the higher profit of €1,500,000. But the story does not end there! Say for example, you discover that all the hard-core fans are located in Brazil, and the other fans are situated in Holland. You can then decide to charge the fans in Brazil the higher price of €25, and the fans in Holland the €10. This then results in profits in two different countries, thus maximising total profits. Of course you are going to follow the method of price discrimination, rather than sticking with one price and only achieving a certain profit.
Lessons learned from this example: Lesson one is the most obvious: Price discrimination increases profits. Lesson two is extremely important; monopolists must be able to separate their customers based on willingness to pay. eg.location as seen in the above passage. However, this doesn’t always work for monopolists. Say for example, a market in Holland found a way of selling the CD to fans in Brazil for a price less than the €25 they are paying. The Dutch market would be making a profit, but they’d also be interfering with the price discriminating monopolist. This process of buying a good for a certain price and selling it to another market at a higher price in order to make a profit is called price arbitrage. Lesson number three, although surprising is very true; price discrimination increases economic welfare. If a single price is used for the CD, then a deadweight loss price will occur, as there will be ‘not so pushed’ fans that aren’t willing to buy it at the higher price. On the other hand, when price discrimination happens, all fans get a copy of the CD and there is a much more efficient outcome, removing all innefficieny that could be possible in monopoly pricing. There is no consumer surplus in price discrimination, just producer surplus, as the consumers aren’t benefitting for buying the book. However, the company will receive a higher profit.
What is perfect price discrimination? To take part in price discrimination, a monopolist must have full knowledge of how to achieve a surplus every single time. We automatically assume that the monopolist is capable of perfect price discrimination. Perfect price discrimination is when the monopolist is well aware of the different amounts different customers will pay. By knowing this, the monopolist can decide what price to charge different people. In reality, however, there is no such thing as perfect price discrimination. We know for a fact that a customer doesn’t just walk into a store holding up a sign that states their willingness to pay, nor do they openly announce it. Because of this, firms must price discriminate by placing people into different groups, for example age category or where they’re from. However, within each category of people, there will always be different levels of willingness to pay, which concludes that perfect price discrimination is in fact impossible. So, does imperfect price discrimination have an effect on welfare? To put it quite simply, there is no answer to that question. All we know is that price discrimination results in a higher profit for the monopolist.
So, what are the examples of price discrimination?! Remember when you were younger, and going to the zoo was the summer event that the whole family looked forward to? Well, chances are you probably weren’t aware of the different prices of tickets in the zoo when you were little. Looking at the prices now, we can see the different ways in which price discrimination is evident when it comes to zoo tickets. For example, the adult tickets range in and around the €15 price mark. However, students, children and senior citizens can get tickets at a reduced cost. For example, a student ticket is €12 when a student I.D. is presented. Why is !
price discrimination carried out when it comes to zoo tickets? Well, it’s simple really. Students, children and senior citizens are on lower budgets. And if they know that they can get their tickets at a reduced cost, more and more will flock to the zoo for a day out! In the long run, everyone benefits. Price discrimination is also evident in the purchase of airline tickets. Have you ever gone online to book flights, and noticed that the tickets may appear cheaper if the passenger is staying in t
How does price DISCRIMINATION WORK? Firstly, large tech companies develop copyrighted products:
However, despite the fact that these products are identical, each company will sell them for diffierent prices in divarious countries, even when they’re downloaded! If you’ve ever been to the US, you’ll notice the huge price difference between iPhones, etc. over there and back home!
For example, in Australia, people often pay 50% more for technology products than in the US (Choice Research 2012). Because these products are copyrighted, the companies can restrict the flow of where they’re sold. Companies combat people buying products abroad / online by geo-blocking and territorial restrictions, for example DVD regions: !
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heir destination for one or more nights? But why should the airline care whether or not a passenger is staying overnight, or flying back on the same evening? Well, it helps to distinguish between the business people and the people travelling for their own enjoyment or personal reasons. A business person is MORE THAN LIKELY going to want to return home on the same evening, as their trip is not intended to be fun, and are willing to pay a higher price. However, someone travelling for their own leisure is going to be drawn towards staying in their destination overnight, especially because their willingness to pay for dearer flights may not be as high as the business person. Therefore, the airlines make these flights cheaper! Have you ever been drawn towards a newspaper or magazine because it’s written in bold on the cover that there’s a coupon inside for money off a day trip out, or perhaps a certain good in a supermarket? Well, this is yet another example of price discrimination. Many people, such as the ‘unique’ individuals on Extreme Couponing will be completely on the ball when they see advertisements like that, simply because it’s how they get by. However, a well-off individual is not going to give the coupon a second glance, as they will have a higher willingness to pay for a good.
Public Policies towards Monopolies! Throughout our study of monopolies and competitive markets, we have learned that monopolies aren’t very good at allocating resources efficiently, in complete contrast to competitive markets. We have seen that it is almost impossible for monopolies to produce the correct amount of output, and as a result have to mess around with their prices, charging customers ABOVE marginal cost. It is the job of the policy makers to respond to the issue of monopolies and try to solve the problem. They can do this in many ways, or they can do nothing. We will now look at three examples of steps that can be taken by policy makers to deal with the issue. 1) Policy makers can attempt to make monopolies more competitive. 2) They can attempt to regulate the behaviour of monopolists, very often without success though. 3) They can transform private monopolies into public enterprises, however this is often met with protest. 4) Do absolutely nothing. In very industry-focused countries around the world, there must be a step by step process for dealing with issues by firms with huge market power and influence that are not accepted by the public. This can be referred to as many different things, such as ANTI-TRUST LAW, ANTITRUST POLICY, COMPETITION POLICY or COMPETITION LAW. The name is dependent on where in the world you are located. The laws are in place to promote competition.
PROMOTING COMPETITION: Basically, the role of the competition authorities is to cooperate not only with each other but also with the European Union Competition Commission. This makes information sharing much simpler and allows many different activities to be carried out. All of these actions contribute to the enforcement of competition law. But what is competition law? Well, by definition “Competition law is a law that promotes or seeks to maintain market competition by
regulating anti-competitive conduct by companies.” Although all countries may have their own competition legislation (Competition Act 1989 in Britain for example) it must coincide with the European Union legislation. If we go back to our example of the Competition Act of 1989 for a second, we learn that while all competition issues within the UK are dealt with under this, if the situation of cross-border competition comes to light, it must be dealt with under the European Union law. Simple, right? So what else do we need to know about competition legislation? Well, it has three main areas that it deals with. 1) The first area is the aspect of free trade. Competition legislation will act against many different things which may have an effect on free trade, such as cartels and restrictive markets. 2) The second area is the forbidding of any anti-competitive strategies, for example, price fixing. What is price fixing? By definition, it is “”a practice whereby rival companies come to an illicit agreement not to sell goods or services below a certain price.”” 3) Finally, the third area that competition legislation deals with is keeping a close eye on acquisition and joint ventures.
Competition legislation allows the different authorities dealing with competition the right to: !
Fine certain firms know for holding a
restriction on competition; !
Deal with ordering said firms to change
their behaviour; !
Ban certain acquisitions.
If an investigation is carried out, it will have to consider the acquisition and whether or not it is in the interest of the public. This is in recognition of course of the known fact that many companies may join together. They don’t necessarily merge together to reduce competition, but more so to lower their costs, as they will be efficiently producing more. The mergers are now benefitting, and we call these advantages synergies. The benefits of the companies which have come together are obviously going to be much greater than they would be if the companies had decided to produce alone.
However, the government has to have the ability to decipher which of the mergers are of benefit and which aren’t. The government has to possess the ability to measure and also compare the social benefit from the synergies, but they must also be able to measure and compare the social costs of a reduction in competition. For example, in the United Kingdom the Director-General of Fair Trading possesses the job of advising the Secretary of State for Business Innovations and Skills whether or not a certain merger should have an investigation carried out on them by the Competition Commission. If it is decided that yes, this merger requires an investigation, then the Competition Commission will write up a report of conclusions, discussing whether or not they believe the merger being investigation is in the public interest. It is then decided whether or not the merger requires prohibition. However, in rare cases, the Secretary of State may overrule the proposed recommendations that the Competition Commission has suggested. Pictured below are the different logos for several European countries’ Competition Commissions:
REGULATIONS: The problem with monopolies may also be dealt with by implementing regulation on their behaviour. For a natural monopoly, such as water or gas, this may seem simple. The government chooses the price they’re allowed to charge. However, it’s not all easy. How is a government supposed to choose which price to set for said monopoly? Should they go with a price equal to a monopolist’s marginal cost to result in an accurate and efficient allocation of resources? This may seem like the obvious thing to do, but often problems arise. For example, when it comes to natural monopolies, they have declining average total cost. This leads to a marginal cost lower than average total cost. So, setting the price of the natural monopoly equal to marginal cost will only result in money loss for the firm. This can be solved
by regulators with the use of subsidies, however to subsidise, taxes must be increased, and this may be met with various protests. Another solution may be for the regulator to charge a price which is greater than the marginal cost. If the price charged equals average total cost, this will result in a ZERO economic profit for the monopoly. However, a loss in economic efficiency may occur due the monopolist’s price failing to show the marginal cost of producing the good. Another problem involved with marginal-cost pricing being used as a system of regulation is that the monopolist doesn’t possess an incentive to reduce their costs. In a competitive market, many firms will always try to reduce their costs in order to raise their profit. However, if a regulated monopolist is aware that prices will be reduced as soon as costs fall, then the monopolist will not be benefitting at all from these lower costs. When regulation is being used as a practise, they deal with this specific problem by giving the monopolists permission to keep some of the benefits which have arisen as a result of lower costs in the form of higher profit. This practice is said to require a certain amount of departure from marginal-cost pricing. Take the United Kingdom for example. Utility companies there have seen a price caps being used to a huge extent. Price caps are used by regulators and they basically determine that a the ‘real’ price of a product produced by a company should drop below a given number of percentage points per annum. This is said to reflect the rise in productivity yearly. If for example, the percentage point is 4%, then the company can raise their prices every year by the given inflation rate minus this 4%. If productivity however increased to, say 6%, then the profits are going to go up every year. Therefore, price caps are used to encourage the natural monopolies to increase and improve their efficiency and production levels.
PUBLIC OWNERSHIP: When dealing with monopolies, a government may choose to avoid regulations, and take control of the monopoly itself. The industry will then become known as a nationalized industry, as it is now owned by the government. In certain European countries, this is extremely popular, with the governments running many different monopolies such as the telephone companies. It goes without
The NHS in the UK is heading towards privatisation every year, which will affect many people across the country.
saying that economists have a preference for private ownership of natural monopolies, because the ownership of a particular firm may have a major effect on the costs of production. Private owners are determined to minimize costs so long as it benefits them with higher profits. If the managers of a firm cannot keep these low costs at bay, they may be fired. However, on the other hand, if it’s the government and its bureaucrats that are running a monopoly disastrously, the ones that are going to be at a huge disadvantage are the customers, as well as the people paying tax.
DOING NOTHING: Due to the large amount of drawbacks that may occur as a result of the policies towards monopolies, it is often thought that, instead of the government taking part in regulation or other policies activities to try and resolve the monopoly situation, it is best just to leave the problem to itself. An Economist in his natural habitat?!
CONCLUSION: To conclude, we have developed a huge knowledge on the ins and outs of price discrimination (different prices at the zoo!) and learned that it usually only associated with monopolistic firms. We have also learned that perfect price discrimination does not exist, no matter what the monopolist down the street told you! We’ve looked at public policy in relation to monopolies and discovered that sometimes, the best thing to do is absolutely nothing! And not to forget the most important part, we learned the names and logos of several different Competition Commissions in Europe. (You never know, it might come in useful someday!)
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MONOPOLISTIC COMPETITON Monopolistic competition is a type of market structure in which many companies sell products that are similar but not the same. It is a market structure which is between the extreme cases of monopoly and competition. Three major factors determine monopolistic competition: 1. Many sellers: There are lots of companies in competition for one group of customers. 2. Product differentiation: Each company's product is slightly different from the next. This uniqueness can help prevent substitution and create brand loyalty. Each company faces a downward demand curve as it isn't a price taker. 3. Free entry: Companies can enter and exit the market freely. The number of companies in the market keeps changing until economic profits reach zero. Here are some examples of markets with monopolistic competition: o o o o o o o
Video games CDs Vets Hotel accommodation Pest control Opticians Restaurants
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Competition with Differentiated Products ! ! !
How to understand Monopolistically Competitive Markets: 1. You must consider decisions facing an individual firm. 2. Then, see what happens when more firms enter and exit the industry. 3. Now, you’re going to want to compare the equilibrium under monopolistic competition to the equilibrium of perfect competition. 4. Finally, ask yourself if society as a whole would benefit from the outcome in a monopolistically competitive market?
The Monopolistically Competitive Firm in the Short Run: ! Each firm is like a monopoly. ! Each firms’ product is different, hence the downwards sloping demand curve. ! So each firm follows a monopolist’s rule for profit maximisation. ! Which means, it chooses its quantity and price just like a monopoly does. ! In the short run, these two types of market structure are very similar.
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The Monopolistically Competitive Firm in the Long Run: ! As in a monopoly market, price exceeds marginal cost. ! We know this because profit maximization requires marginal revenue to equal marginal cost. ! Also, because the downwards sloping demand curve makes marginal revenue less than the price. ! Just like in a competitive market, price equals average total cost. This is because free entry and exit drive economic profit to zero. ! Because a monopoly is the sole seller of a product without any close substitutes, it can earn positive economic profit, even in the long run.
! By contrast, because there is free entry and exit into a monopolistically competitive market, the economic profit is driven down to zero.
Excess Capacity: • • • •
The quantity that minimizes average total cost is called the efficient scale of the firm. In the long run, perfectly competitive firms produce at the efficient scale, whereas monopolistically competitive firms produce below this level. Firms are said to have excess capacity under monopolistic competition. In other words, a monopolistically competitive firm, unlike a perfect competitive firm, could increase the quantity it produces and lower the average total cost of production.
Mark-Up over Marginal Cost: Sales!Tax!
• A second difference between Markup! perfect competition and monopolistic competition is the Wholesale! relationship between price and Price! marginal cost. • For a competitive firm, price = marginal cost. • For a monopolistically competitive firm, price > marginal cost, because the firm always has some market power. • In the long-run equilibrium, monopolistically competitive firms operate on the declining portion of their average total cost curves, so marginal cost is below average total cost. • So, for price to equal average total cost, price must be above marginal cost.
Monopolistic Competition and the Welfare of Society: • One of the bad things about monopolistic competition is the mark-up of price over marginal cost. • Because of this, some consumers will be deterred from buying the good(s). • This is obviously unwanted compared to the first-best outcome of price equal to marginal cost, but there’s no easy way for policymakers to fix the problem. • To enforce marginal-cost pricing, policymakers would need to regulate all firms that produce differentiated products. • Since there are so many of these firms, this would be an impossible task. • Also, regulating monopolistic competitors would entail all of the same problems of regulating natural monopolies. • Because monopolistic competitors are making zero profits already, making them lower their prices to equal marginal cost would cause them to make losses. • Then the government would have to subsidise them to keep them in business, and to do so they would have to raise taxes and so on. • Policymakers may decide it is better to live with the inefficiency of monopolistic pricing.
• Another problem with monopolistic competition is that there’s usually too much or too little entry. • Too much entry can have two effects: 1. The Product-Variety Externality. Because consumers get a surplus of choice from the introduction of new products, entry of a new firm conveys a positive externality on consumers. 2. The Business-Stealing Externality. Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms. • Depending on which externality is larger, a monopolistically competitive market could have either too few or too many products. • Conversely, because perfectly competitive firms produce identical goods and charge a price equal to marginal cost, neither of these externalities exists under perfect competition. • In the end, monopolistically competitive markets do not have all the desirable welfare properties of a perfectly competitive market. • Yet, because the inefficiencies are subtle, hard to measure and to fix, there’s no easy way for public policy to improve the market outcome.
Contestable Markets: • The theory of Contestable Markets was developed by William J. Baumol, John Panzar and Robert Willig in 1982. • The key characteristic of a perfectly contestable market was that firms were influenced by the threat of new entrants into a market. • The more highly-contestable a market is, the lower the barriers to entry. • The threat of new entrants may make firms behave in an unsociable manner. • The suggestion by Baumol and colleagues was that firms may deliberately limit profits made to discourage new entrants. • Profits may be limited by what is known as entry limit pricing.
• Firms may practise predatory or destroyer pricing whereby firms purposefully make losses by holding the price below average cost to undermine new entrants. • There are other tactics deployed by firms to drive out new entrants, such as operating at over-capacity, which floods the market and drives down price. • Firms will also carry out aggressive marketing and branding strategies to ‘tighten’ up the market or find ways of reducing costs and increasing efficiency to gain competitive advantage. • Hit-and-run tactics might be evident in a contestable market where firms enter the industry, take the profits and get out quickly. • In other cases firms may indulge in what is termed cream-skinning (identifying parts of the market that are high in value added and exploiting those markets). • There are numerous examples of markets exhibiting contestability characteristics including financial services, airlines, the IT industry, internet service providers, energy supplies and the postal service. • The key to analysing market structures, could be argued to be the focus on the degree of freedom of entry and exit. • If policymakers can keep barriers to entry as low as possible, i.e. try to ensure a high degree of contestability, there is more likelihood that market outcomes will be efficient.
Monopolistic Competitors in the Short Run:
Monopolistic Competitors in the Long Run: Demand Curves:
Monopolistic versus Perfect Competition:
ADVERTISING In one 45-minute journey, the average London commuter is exposed to more than 130 adverts (Gibson 2005). Brands usually spend 10-20% of revenue for advertising, whereas on the flip side, firms that sell homogenous goods i.e. crude oil, spend little money on advertising (Mankiw & Taylor 2012). Adverts help create brand loyalty, which can make a big difference for the company in the long run. Advertising is changing everyday. In the past, there was more of a focus on print ads for magazines and newspapers, whereas nowadays, online advertising on social media is becoming more and more popular. This has also led to more subtle advertising through product placement, particularly in music videos and films. Even more recently, popular YouTubers and bloggers can be sponsored to endorse new products.
There has been much critique of ads over the years, especially the more subtle the ads become. On the next page we’ll look at the debates for and against advertising!
DEBATES FOR AND AGAINST ADVERTISING: Against Advertising: • Advertising manipulates people's personal tastes by being more psychological than informational. For example, perfume ads never tell viewers what the perfume actually smells like—they just show images of a beautiful, glamourous lifestyle to sell it instead. See below for examples! • Adverts can create desires that we didn't need before, and still don't really need. • Some say that advertising stops competition by lying to customers telling them that the products are more different than they really are. By creating brand loyalty and the idea of product differentiation, buyers aren't as concerned with price changes between similar goods. This means a less elastic demand curve, and each firm chares a larger mark-up over marginal cost.
For Advertising: • Advertising can be informative, by telling buyers the cost, locations and new innovations of products. People can make better choices on which product to buy. • Some say advertising creates competition which enhances the market. Customers are more informed so can take advantage of price differences—so, each company has less market power. • Advertising lets new companies enter the market, by attracting customers from existing ones.
Does this perfume smell like a lion then? Will I look like this if I use it? Hmm...
Informative adverts to help customers make better decisions regarding prices and quality.
From left to right, bottom to top: “Finger lickin’ good,” “Have it your way,” “Das Auto,” “Open happiness,” “Because you’re worth it,” “Think different,” “Impossible is nothing,” “Make believe,” “Keeps going and going and going,” “Zoom zoom,” “Eat Fresh.”
Brands use taglines to create brand memorability—can you get the taglines for these big brands? !
Advertising as a Signal of Quality: On the surface, most ads don’t tell us a lot about what’s being advertised (perfume adverts are probably the worst for this!) However, people in favour of ads argue that even a company spending so much money on ads suggests to us the quality of the product. People also rationally want to try new products that are advertised, and are also curious to see if the product is as good as all the money spent on advertising them. The info given in an ad is not the most important thing—just the ad’s existence and expense is.
Brand Names: Looking at the brand logos above, most of us don’t even have to think twice about the names of each. There are two types of firms in many markets: 1. That sell branded products. 2. That sell generic substitutes. Like advertising, some people are in favour and against brand names: Against say that branding makes people think that products are different when they’re really not. For example, could you tell the taste difference between a Lidl Ginger Nut and McVitie’s Ginger Nut? Advertising creates irrationality in choosing what products to buy. Economist Edward Chamberlin said that brand names were bad for the economy as they made this problem worse!
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For say that brand names ensure people know the quality of the goods they’re buying. Brand names give both information and incentive to the buyers. Brand names also give incentive to the producers to keep up quality, as they don’t want a scandal to ruin their brand image. For example, if someone found a worm in a bag of crisps, the brand’s image would be ruined on national news. So, it’s in the company’s interest to keep quality / hygiene / taste standards high so they don’t ruin their brand. The crux of the argument is: Are consumers rational in choosing products when they shop—are they able to really justify buying popular branded products? However, it’s important to note that just because something’s branded doesn’t mean it’s of high quality! For example, Lidl and Aldi’s brand names are mainly meant to promote their value for money products, rather than superior quality. It’s interesting to see that these shops do have brands that are meant to emulate higher quality products at an affordable price too, as seen below in Lidl’s Deluxe Range, which even includes caviar!
Conclusion: • Monopolistic competition is simply a mix of monopoly and competition. • Monopolistic competition faces a downward demand curve, like a monopoly— and so charges the price above the marginal cost. • Monopolistically competitive firms produce differentiated products, which are promoted through branding, advertising etc.
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How well do you know your logos?!
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Market Structures: Oligopoly Oligopoly is a type of imperfect competition, and it occurs when there is competition between a small number of very large firms. In an oligopolistic market, there may be hundreds of firms in the industry but the sales are dominated by a small number of very big firms. This means that the market is concentrated by a small few firms. The concentration ratio refers to the proportion of total market share that is held by a small number of large firms. For example, four music companies control 80% of the market: Universal Music Group, Sony Music Entertainment, Warner Music Group and EMI Group. The small amount of large firms makes competition between these firms unlikely. Instead, firms will collude with each other: collusion occurs when rival firms in an oligopolistic market work together for their mutual benefit. The firms interact strategically and as a result, the actions of any one firm in the market can have a great impact on the profits of all the other sellers.
Collusion is technically illegal, and doesn’t usually work as businesses don’t stick to the rules. However it can still occur, for example the recent Forex scandal!
Traits of Oligopoly: 1) There are a small number of large firms in the market. For example, supermarkets such as Tesco, Supervalu and Dunnes Stores. 2) Product Differentiation: firms in an oligopolistic market sell goods that are similar. However, in order to compete with each other, firms in an oligopolistic market will engage in product differentiation. For example, firms selling toothpaste are aware that all toothpastes are bought for one purpose: to clean teeth. However, some firms will try set their toothpaste apart from other toothpastes by advocating a toothpaste that whitens, or a toothpaste that freshens breath for up to 24 hours. 3) There is interdependence between the small number of large firms that dominate the market. This interdependence means that any large decision by one firm will influence the decisions made by the other firms in the market. Each firm is influenced by what it thinks the reaction of its rival firms will be. 4) Firms collude. Collusion occurs frequently in oligopolistic markets. This happens when the small number of large firms make an agreement about quantities produced or about changes in price. The group of firms who partake in such an agreement are called a cartel. The firms within the cartel now act in unison. However, collusion is not always possible as there are certain laws that prohibit such agreements amongst firms in order to protect the consumer, and prevent oligopolistic firms from earning monopolistic profits. In addition, cartel members may argue over how to split profits.
Oligopolistic firms would in fact be better off if they cooperated together, and reached a monopoly outcome—through collusion. However, firms in an oligopoly tend to pursue their own self-interest and because of this they do not reach the monopoly outcome and they do not maximise their joint profit. Each oligopolistic firm wants to increase the quantity of goods they produce in order to capture a larger share of the market. When oligopolistic firms are deciding what quantity of goods to produce, they must consider two things: 1. The output effect 2. The price effect. For example, if a well owner is considering raising production by one litre, they must consider the output effect. Because price is above marginal cost, selling one more litre of water at the given price will increase profit. They must also consider the price effect: raising production will also raise the total amount of water sold, which will in turn lower the price of water and lower the profit on all the other litres sold. If the output effect exceeds the price effect, the well owner will increase production. However, if the price effect exceeds the output effect, the well owner will not increase production. The larger the number of firms in the market, the less impact an individual seller will have on the market price. Therefore, as the oligopolistic market grows in size, the magnitude of the price effect falls. When the oligopoly grows extremely large, the price effect completely disappears and is replaced by the output effect. If an oligopoly this large occurs, each firm will increase production for as long as price exceeds marginal cost. Thus, as the number of sellers in an oligopolistic market increases, the market becomes more and more like a competitive market.
Price Rigidity: Price rigidity often occurs in oligopolistic markets. This means that prices in an oligopolistic market tend to stay the same over time, even though this may seem surprising due to the changes in demand and supply in such markets. Price rigidity occurs because the goods being produced are homogenous, so if a firm raises its prices, rival firms will not follow suit. Therefore, the individual firm will avoid raising its prices because it does not want demand for its good to decrease. Because of this, firms in an oligopolistic market engage in non-price competition. This occurs when firms try to compete with each other by methods other than changing price. Examples of non-price competition include advertising, buy one get one free schemes, branding and an emphasis on quality rather than on price. Even though oligopolies would like to reach the monopoly outcome, the cooperation required to do so is difficult to maintain.
Game Theory: Game theory is the study of how people behave in strategic situations. Because there are only a small number of firms in an oligopolistic market, each firm must act strategically. Each firm takes into account the decisions made by other firms, and is aware of the influence that other firm’s profits will have on their own profit. When a firm makes a decision (chooses a strategy) there are payoffs that arise as the result of making that decision. Each firm is assumed to be able to identify the payoff or the strategy that they choose. However, each firm also knows that their rival also faces the same decisions and strategies and that these will also have associated payoffs. Each firm therefore has to put themselves in the position of their rival firms before choosing a strategy. These
choices are represented as a payoff matrix which is a table showing the possible combination of payoffs depending on the strategy chosen by each firm. An important ‘game’ that occurs in oligopoly is called the prisoner’s dilemma. The prisoner's dilemma shows why two individuals might not cooperate, even if it is collectively in their best interest to do so. Consider an oligopoly with two countries that produce oil: Iran and Saudi Arabia. After negotiating, the countries agree to keep oil production low in order to keep world demand for oil high, and world oil prices high. Each country will now have to decide whether they will produce at the agreed production level, or if they will ignore the agreement and produce at a higher level.
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Intro! ! The!majority!of!early!economic!structures!were! stumbled!upon!by!mathematicians!rather!than!economists:! This!is!epitomised!in!the!case!of!John!Nash,!as!a! mathematician!who!won!the!Nobel!Prize!in!economics!for! his!work!on!equilibrium!points!in!an!oligopolistic!market. ! The!definition!of!an!oligopolistic!market!is!“a!market! structure!in!which!a!few!firms!dominate.!When!a!market!is! shared!between!a!few!firms,!it!is!said!to!be!highly! concentrated.!Although!only!a!few!firms!dominate,!it!is! possible!that!many!small!firms!may!also!operate!in!the! market.”1! The!Nash!Equilibrium!is!defined!as!“a!stable!state!of!a! system!involving!the!interaction!of!different!participants,!in!which!no!participant!can!gain!by! a!unilateral!change!of!strategy!if!the!strategies!of!the!others!remain!unchanged.”2! Nash!was!the!first!to!accurately!describe!these!occurrences,!however,!in!2005!Thomas!C.! Schelling!and!Robert!J.!Aumann!won!the!Nobel!Prize!for!their!work!on!cooperative!and!nonO cooperative!games.!This!continuous!study!of!oligopolistic!market!structures!and!people’s! behaviours!was!fuelled!by!every!firm’s!desire!to!minimize!costs,!while!maximizing!profits.! Every!firm!in!an!oligopoly!strives!to!hold!a!monopoly.!! !
Cooperative!and!Non!Cooperative!Games! ! The!prisoners’!dilemma!is!a!basic!way!of! describing!cooperation!between!firms.!If!there!are! two!firms!in!an!oligopoly!they!are!naturally! competing!against!each!other!to!draw!a!larger! income!from!the!market.!However!if!they!were!to! cooperate!it!could!be!detrimental!to!society,! cooperation!could!lead!to!a!monopoly.! ! A!monopoly!would!be!bad!for!society!as!it!leads! to!higher!prices!and!less!innovation!due!to!the!lack! of!competition!in!the!market.!NonOcooperative! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! 1 !Nash equilibrium (2015) in Wikipedia. Available at: https://en.wikipedia.org/wiki/Nash_equilibrium (Accessed: 1 December 2015). ! 2 !Oligopoly (2015) Available at: http://www.economicsonline.co.uk/Business_economics/Oligopoly.html (Accessed: 1 December 2015).
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firms!are!always!striving!to!deliver!the!most!innovative!product!! in!order!to!attract!more!sales,!a!good!example!of!this!is!how!! Apple!and!Samsung!are!constantly!releasing!newer!products!in! an!attempt!to!draw!consumers.! ! ! ! !
! Cooperation!occurs!when!two!firms!that!have!been!competing!against!each!other!for!a! prolonged!period!of!time!realize!that!they!could!maximize!profits!if!they!were!to!cooperate.! However,!this!is!rare!in!the!present!day:!The!most!prominent!examples!would!be!cartels!that! have!come!together!because!its!in!each!others!best!interests!to!maximize!profits.! Cooperation!by!companies!in!oligopolies!is!difficult!to!achieve!because!defection!is!in!the! best!interest!of!each!individual!firm.! ! There!is!also!the!case!of!collusion:!If!an!oligopolistic!market!appears!to!have!become! uncompetitive,!it!could!be!suspected!that!collusion!is!taking!place.!Tacit!collusion!is!defined! as!“When!firm!behavior!results!in!a!market!outcome!that!appears!to!be!antiOcompetitive!but! has!arisen!because!firms!acknowledge!that!they!are!independent.�3!Collusion!is!more! common!in!places!where!large!shops!are!grouped!together!and!they!are!all!selling!relatively! similar!products.! ! Models!are!used!to!portray!market!structures!and!the!two!most!prominently!used!to! determine!oligopolistic!situations!are!the!Cournot!Model!and!the!Bertrand!Model.! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! 3 !Oligopoly (2015) Available at: http://www.economicsonline.co.uk/Business_economics/Oligopoly.html (Accessed: 1 December 2015).
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Models!are!used!so!that!firms!can!easily!evaluate!where!best!to!set!prices!in!relation!to! their!demand!curve!in!order!to!maximize!their!profits.! There!is!also!the!Stackelberg!Model!which!takes!more!relevant!factors!into!account.! !
The!Cournot!Model!! This!model!takes!a!duopoly!and!makes!certain! assumptions!in!order!to!predict!the!amount! produced!by!each!firm.!The!assumptions!made! are!as!follows:!! • There!is!more!than!one!firm!and!all! firms!produce!a!very!similar!product! • There!is!no!cooperation!or!collusion! between!firms! • Each!firm’s!output!effects!the!market!price!of!the!good! • The!firms!are!economically!rational! • They!act!to!maximize!profits.! In!the!Cournot!Model!we!first!hear!of!reaction!functions,!this!is!defined!as!“The!decision!of! one!firm!on!a!particular!issue!such!as!the!profit!maximizing!output!in!response!to!the!profit! output!maximising!decisions!of!its!rivals.”4!The!Cournot!Model!suggests!that!firms!will!each! make!decisions!assuming!that!their!rival!would!not!react,!this!eventually!leads!to!the!market! reaching!an!equilibrium!position.!
! The!Bertrand!Model!! This!model!suggests!that!again!firms!operating! in!a!duopoly!compete!on!price,!according!to!the! Bertrand!model!the!equilibrium!position!of!an! oligopoly!will!eventually!resemble!that!of! imperfect!competition.!
! The!Stackelberg!Model ! In! this! instance! more! factors! are! taken! into! consideration,! such! as! game! theory,! which! leads! firms! to! anticipate! its! rivals’! decisions! and! act! first! to! counteract! what! its! rivals! may! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! 4 !Taylor, M. P. and Mankiw, G. N. (2011) Economics. 2nd edn. United Kingdom: Cengage Learning EMEA. !
have! been! planning.! This! model! is! primarily! based! on! the! advantages! a! firm! can! gain! by! making!the!first!move.! If!a!firm!makes!the!first!move!they!will!temporarily!hold!the!upper!hand!over!its!rival,!this! gives! them! time! to! invest! the! extra! profits! into! innovation,! which! will! push! them! further! ahead!of!the!competition.! !
Public!Policy!Toward!Oligopolies ! ! There!are!many!ways!that!governments!can! influence!markets,!however!a!governments! primary!goal!in!relation!to!oligopolies!is!to!put! a!stop!to!collusion!or!cooperation!of!any!sort! as!this!is!the!worst!outcome!for!society!in! general.!The!primary!ways!in!which!they!go! about!doing!this!are!restraint!of!trade!and!competition!law,!! “Section!4(1)!prohibits!and!renders!void!"all$agreements$between$undertakings,$decisions$ by$associations$of$undertakings$and$concerted$practices$which$have$as$their$object$or$effect$ the$prevention,$restriction$or$distortion$of$competition$in$trade$in$any$goods$or$services$in$the$ State$or$in$any$part$of$the$State".!!The!Act!lists!some!specific!types!of!behaviour!which!are! expressly!prohibited.!!These!include!agreements!which:! fix!prices! limit!or!control!production!or!markets! share!markets!or!sources!of!supply! apply!dissimilar!conditions!to!equivalent!transactions!with!other!trading!parties! or!! • attach!supplementary!obligations!to!a!commercial!contract!which!have!nothing! to!do!with!the!subject!of!the!contract!(e.g.!tying).”5! • • • •
There! has! also! been! much! controversy! over! contribution! policies! such! as! retail! price! maintenance—this! is! where! a! wholesaler! sets! a! minimum! retail! price! for! its! goods! that! is! higher!than!what!it!sells!them!for.!This!is!an!ill!favoured!business!practice.! There! is! also! predatory! pricing,! this! is! far! less! common! among! modern! firms! as! it! negatively!effects!their!income!in!order!to!drive!away!competitors!so!as!they!can!remain!in! control! of! a! monopoly.! Finally! there! is! tying,! when! two! products,! one! being! desirable! the! other!being!far!less!desirable!are!sold!together,!the!desirable!product!will!sell!regardless!of! the!price!therefore!income!is!increased!because!there!is!no!alternative! ! !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! 5 !The competition authority: Enforcing competition law » competition law(2015) Available at: http://www.tca.ie/EN/EnforcingCompetition-Law/Competition-Law.aspx (Accessed: 1 December 2015).
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Bibliography: ! Mankiw, N.G. and Taylor, M. 2014. Economics. Andover: Cengage Gibson, O. 2005. ‘ Shopper’s eye view of ads that pass us by.’ Available online at: http://www.theguardian.com/media/2005/nov/19/advertising.marketingandpr (accessed 20 November 2015).
Graphs from Economics by Mankiw and Taylor (as above). All images from the Internet unless otherwise stated.
Credits: Written by The Policy Pals: Choy-Ping Clarke-Ng Cian McCarroll Saira Munir Chloe O’Toole Vanessa O’Connell Tom Sheerin Edited by Choy-Ping Clarke-Ng
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