A. Perfect Competition 1. Study Paradigm of Market (Industrial Organization) Market Structure (S) / Behaviors or Conduct (C) / Performance (P)

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1 Lecture 07 Market Structure (I) A. erfect Competton. Study aradgm of Market (Industral Organzaton) Market Structure (S) / Behavors or Conduct (C) / erformance (). erfect Competton Condtons or Assumptons a) Many buyers and sellers: fragmented ndustry so that each company has neglgble market share that cannot change the whole structure b) Homogeneous (or dentcal) product: Consumers wll not ncur addtonal costs n collectng addtonal nformaton. Ex) Gold, slver etc. c) erfect moblty of nputs: no entry or ext barrers d) erfect nformaton e) No transacton cost f) rce takers: prce s now a parameter *.C. s an deal type of market structure wth good predctablty of market. 3. roft maxmzaton of a representatve frm $ MC AC C * MR = A B AVC E s O Q* Q Supply curve: MC curve above AVC. ont : Shut-own ont ont E: Beak-Even ont emand curve: MR curve at * Total revenue: *OQ*C Total costs: AOQ*B Economc proft: *ABC Any ponts between and E: A frm should produce some output even though the frm s facng economc losses. Why? 4. Industry Supply Curve n SR n Q = Q + Q + L + Q = Q( at a gven ) M n = *5. Resdual emand Elastctes (amount demanded from -th frm)=(ndustry demand) (amount produced by all other frms) dx dq dqs dx x = Q QS. fferentatng ths equaton w.r.t. prce, = ( Qε = ) d d d d x dx dq Q dq Q Q dq Q dqs QS / Q = + d Q x d Q x / Q S S = + ε d x d x Q d x Q QS ε = e k + e S ( k ) k Q x QS x QS ( Q = +, and let = k, then = k ) Q Q Q Q Q S Intermedate Mcroeconomcs 5

2 The smaller k s, the largerε, whch depends on supply elastctes of other frms. In compettve market, ) k s relatvely small. ) even f k s not small but f es s elastc, then ε s elastc. B. Monopoly. Sources of Monopoly a) Control of Scarce Inputs (OEC, ebeers etc.) b) atents or Franchse / Lcense Scheme (M, RN, Mconald s, Burger Kng etc.) c) Government Enforced Barrers (MLB, NFL, NBA etc.) d) Large Economes of Scale: Natural Monopoly e) Merger and Acquston (M&A) f) Illegal ways to sustan monopoly power (Brbe, Lobby, atent kllng, etc.). Short-Run Analyss a) ervaton dtr( Q) MR( Q) = = + Q d and FOC of proft maxmzaton s MR( Q) = MC( Q) dq dq So, = MR ( Q ) Q d dq > MC( Q) ( Qd / dq < 0 ) MC M C SAC B A M Q M MR emand Q 3. Margnal cost and prce elastcty of demand: Inverse Elastcty rcng Rule (IER) At pont M, MR( Q) = MC( Q). Accordng to Amoroso-Robnson formula, we know MR( Q) = MC( Q) =. So, * MC * = * (as ε ε ε, MC) The l.h.s. of above equaton s the monopolst s optmal markup of prce over margnal cost, expressed as a percentage of the prce. For ths reason, ths equaton s called the nverse elastcty prcng rule(ier). And l.h.s. s called Lerner Index of market power. Intermedate Mcroeconomcs 6

3 4. Monopolst s emand for Inputs If the nput market s compettve, then ths monopolst should take prces of nputs as gven. We can easly derve the relatonshp usng proft as a functon of L and K, not Q. Let TR() and TC() denote total revenue and total cost functon, respectvely. Then, we know TR = TR( Q) = TR( f ( L, K)) and TC = wl + rk. Based upon these expressons, we can get π = π( L, K) = TR( L, K) TC( L, K) º : π = π = L K 0. So, TR( L, K) = TC( L, K) = w, TR( L, K) = TC( L, K) = r K K TR( L, K) = TR( f ( L, K)) dtr = f dq L = MR M L TR( L, K) dtr = f = K dq K MR M K (some textbooks are usng M (margnal physcal product) nstead of M) So, the fnal expresson can be MRL( L, K) = MR( Q) ML( L, K) = w () MRK( L, K) = MR( Q) MK( L, K) = r where MR s margnal revenue product, whch s smlar to VM (value of margnal product, M ) n perfectly compettve goods market. Now, we need to thnk how equaton () s related to MR( Q) = MC( Q). We have total cost functon TC( Q) = C( f ( L, K)) wl + rk. fferentatng ths functon w.r.t L and K, dtc( Q) f ( L, K) dq dtc( Q) f ( L, K) dq K w r, whch can be rewrtten as º : SOC would be MR < 0, MR < 0 LL KK MC( Q) ML ( L, K) w MC( Q) M ( L, K) r 5. rce scrmnaton: Non-lnear rcng a) Condtons Frm should be able to dvde ts consumer group nto several subgroups based upon prce elastcty and any related factors. Resale or transfer between any dfferent subgroups wll not be allowed. b) TR = TR( Q), TR = TR( Q). TC = TC( Q) TC( Q+ Q ) π( Q, Q ) = TR ( Q ) + TR ( Q ) TC( Q + Q ) FOCs of proft maxmzaton are π ( Q, Q) = TR ( Q) TC ( Q) = 0 MR( Q) = MR( Q) = MC( Q) π ( Q, Q ) = TR ( Q ) TC ( Q) = 0 K () Intermedate Mcroeconomcs 7

4 From the last expresson, we can get mportant result usng Amoroso-Robnson formula MR = = = MR. So the rato of equlbrum prces wll be ε ε ε ( ε ) ε If ε > ε, then <. = =. So, ( ε ) ε If ε ε, then < >. (3rd -degree dscrmnaton) ε c) st -degree and nd -degree rce scrmnatons A B O Q d Q Q d) rce scrmnaton usng hurdles Usng very cheap devces that make customers reveal ther own prce elastctes. Ex) Coupons, Sale, mal-n rebates, matnee etc. 6. Other Sales Strateges a) Two-part Tarff rcng The consumer pays a fxed (access) fee for servce, plus a varable charge per unt purchased. Ex) utltes (electrcty and gas), amusement parks and theme parks, sports clubs (racquet courts, aerobc classes, golf clubs etc). b) Tyng and Bundlng Tyng: a seller s condtonng the purchase of one product on the purchase of another. Technologcal tes: specfc plug-n nterface may be hard to copy or actually protected from copyng by IR. ex) nk-jet prnters Contractual tes: consumer s bound by contract to consume both products from the same Source. ex) Harley-avdson Motorcycles. 7. Qualty scrmnaton A frm wll try to reduce the qualty of the lower-qualty good (economy ar servce) so as to reduce the ncentve of people wth a hgh wllngness to pay to swtch from the hgh-qualty good (frst or busness class) when the frm ncreases ts prce. 8. Welfare Issues n Monopoly The major concern s that monopoly msallocates resources by producng the wrong amount of a good, where prce does not equal margnal cost. Intermedate Mcroeconomcs 8

5 A CS m Q ( ) = A bq c Monopoly roft WL MC = c Q m MR(Q) Q S =(Q) Suppose we are gven the demand functon as Q ( ) = A bq, and the cost s fxed at c. Wth ths nformaton, we are requred to solve the followng questons: A c a) MR( Q)= A bq b) Qm = A c c) m b = + c) d) π m = 4b ( m c)( QS Qm) c) A c e) WL = = (Q QS = ) 8b b m) Qm c) f) CS = = 8b 9. etermnants of WL d Q WL = d dq = d dq dq Q If we assume constant costs, so that d = m c, then upon gatherng terms, ths s equvalent to WL = ε m Q m L, where L s Lerner Index. Ths suggests that the neffcency assocated wth monopoly prcng s greater, the larger the elastcty of demand, the larger the Lerner ndex, and the larger the ndustry (as measured by the frm s revenues). However, such an nterpretaton would be ncorrect snce L depends on the elastcty of demand. As ε ncreases, a proft-maxmzng monopolst responds by decreasng L. Startng wth Harberger (954), estmates of the economy-wde loss from the exercse or market power have been calculated based on the above equaton. Harberger estmated that the WL n the manufacturng sector n U.S. was approxmately 0.% of G. The relatvely small estmates are due to low observed values of L and hs assumpton that the elastcty of demand was one. Small values of L are consstent wth proft maxmzng f demand s relatvely elastc, not unty. Cowlng and Mueller (978) observe that f a frm s a monopolst and proft maxmzes, then Intermedate Mcroeconomcs 9

6 m ε = L and the equaton wll be WL = π. Ther estmates based on ths equaton suggest that WL could be on the order of 4% of GN. However, the use of ths assumes that all frms are monopolsts, and ths s clearly as unsatsfactory as assumng that L s ndependent of the elastcty of demand. 0. X-neffcency A monopoly may spend too much on advertsng, product dfferentaton, or nvestment n excess producton capacty. Tullock (967) and osner (975) argue that the welfare costs of monopoly nclude expendtures on lobbyng and campagn contrbutons ntended to obtan tarff protecton, patent protecton, and other preferental government treatment. In the extreme, a frm would be wllng to spend an amount up to the potental monopoly profts to become a monopolst. Such rent-seekng actvtes would ncrease the welfare costs of monopoly. Cowlng and Mueller consdered ths ssue carefully. They used advertsng expendtures to approxmate the costs of monopolzaton to socety. Addng these costs to ther estmate of WL, they estmated that the welfare cost of monopolzaton may be as hgh as 3 percent of G. In less compettve markets, there s less pressure on frms to use nputs effcently. Ineffcent monopolsts may not be drven out of the market even n the long run. We consder ths effect on costs, called X-neffcency (by Lebensten, 966). If monopolzaton rases costs, the WL s larger. In addton, the costs of producng the monopoly output level are hgher. The mportant welfare pont s that f ncreasng competton n monopolzed markets would lead to reduced costs, then estmates of welfare loss based on WL trangles such as Harberger s wll be far too low. Whle the controversy over the welfare cost of market power has not been resolved, t s possble to step back and make three observatons. Frst, even a relatvely small percent of GN represents a consderable amount of resources. Second, any strategc behavor on the part of frms ntended to obtan or protect ther monopoly postons rases the costs of monopolzaton substantally. Thrd, n some ndustres, the potental gans to socety from decreasng monopoly power are large. M C C Increase n costs due to X-neffcency Increase n WL due to X-neffcency MC M =AC M MC C =AC C emand Q M MR Q C Q Intermedate Mcroeconomcs 30

7 . Benefts of Monopoly a) Scale Economes Olver Wllamson (968) has suggested that f a merger to monopoly results n a decrease n ndustry-wde costs, these cost savngs could easly compensate for any ncrease n allocatve neffcency. Lost CS due to monopoly prcng M C Cost Savngs due to lower cost of monopoly MC C MC M =(Q) MR(Q) Q M Q C Q It s the value of the resources that were requred under competton to produce Q M unts, but are not requred to produce that output level under monopoly. Wllamson s pont s that t does not take very large cost savngs to compensate for the allocatve neffcency. b) Research and evelopment (R&) Joseph Schumpeter (965) argued that market power s a necessary ncentve for research and development. He contended that wthout the lure of monopoly profts frms would have nsuffcent ncentves to undertake research and development. Moreover, t was a mstake to focus on allocatve neffcency f that neffcency made possble nnovaton of new products and technologes. For t s ths knd of nnovaton that s responsble for economc growth and substantal qualtatve ncreases n lvng standards.. Regulatng Monopoly a) Margnal Cost rcng b) Average Cost rcng c) Two-ter rcng d) Rate-of-Return Regulaton Intermedate Mcroeconomcs 3