Market Structure & Imperfect Competition

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1 In the Name of God Sharif University of Technology Graduate School of Management and Economics Microeconomics (for MBA students) ( st term) - Group 2 Dr. S. Farshad Fatemi Market Structure & Imperfect Competition

2 Most markets fall between the two extremes of monopoly and perfect competition An imperfectly competitive firm would like to sell more at the going price faces a downward-sloping demand curve recognizes its output price depends on the quantity of goods produced and sold Microeconomics (for MBA students) Dr. F. Fatemi Page 119

3 An oligopoly an industry with a few producers each recognizing that its own price depends both on its own actions and those of its rivals. In an industry with monopolistic competition there are many sellers producing products that are close substitutes for one another each firm has only limited ability to influence its output price. Microeconomics (for MBA students) Dr. F. Fatemi Page 120

4 The Minimum Efficient Scale and Market Demand The minimum efficient scale (MES) is the output at which a firm s longrun average cost curve stops falling. The size of the MES relative to market demand has a strong influence on market structure. Microeconomics (for MBA students) Dr. F. Fatemi Page 121

5 The degree to which monopolistically competitive prices can differ from the competitive ideal depends on: the number of other competitors the ease with which competing firms can expand their businesses to accommodate new customers (the cost of expansion) the ease with which new firms can enter the market (the cost of entry) the ability of firms to differentiate their products, by location or by either real or imagined characteristics (the cost differentiation) public awareness of price differences (the cost of gaining information on price differences) Given even limited competition, the firm should face a relatively elastic demand curve; certainly more elastic than the monopolist s. Microeconomics (for MBA students) Dr. F. Fatemi Page 122

6 Indexes to Measure Market Concentration Suppose there are F firms in a given market and the market share of each firm is defined as (it is clear that i=1 s i = 1): F s i = q i i q i (i {1, 2,, F}) N-Firm Concentration Ratio: The market share of the largest N firms in the industry N F. N ordering the firms so that: CR = s i i=1 s 1 s N s F Microeconomics (for MBA students) Dr. F. Fatemi Page 123

7 The Herfindahl index: The sum of the squares of the market shares of all the firms in the market: F HHI = s i 2 i=1 It also can be normalized (range from 0 to 1): HHI = HHI 1 F 1 1 F The Entropy index: The sum of the market shares multiplied by their logarithms: F EI = s i ln s i i=1 Microeconomics (for MBA students) Dr. F. Fatemi Page 124

8 Monopolistic Competition So far we studied two extreme cases of perfect competition and monopoly. Because the product sold by the monopolistically competitive firm is slightly different from the products sold by competing producers, the firm faces a highly elastic, but not perfectly elastic, demand curve. Microeconomics (for MBA students) Dr. F. Fatemi Page 125

9 many firms no barriers to entry product differentiation so the firm faces a downward-sloping demand curve The absence of entry barriers means that profits are competed away... Microeconomics (for MBA students) Dr. F. Fatemi Page 126

10 Monopolistic competition in the short run As do all profit maximizing firms, the monopolistic competitor will equate marginal revenue with marginal cost. It will produce Q mc units and charge price P mc, only slightly higher than the price under perfect competition. The monopolistic competitor makes a short-run economic profit equal to the area ATC 1 P mc ab. The inefficiency of its slightly restricted production level is represented by the shaded area. Microeconomics (for MBA students) Dr. F. Fatemi Page 127

11 Monopolistic competition in the long run In the LR, firms will enter the market, shifting the monopolistic competitor s demand curve down from D 1 to D 2 and making it more elastic. In equilibrium firm s demand becomes tangent to the downward sloping portion of the firm s long-run ATC. (The firm is making zero economic profit) Unlike the perfect competitor, this firm is not producing at the minimum of the long-run average total cost curve Q m. In that sense, it is underproducing. This underproduction is also reflected in the fact that the price is greater than the marginal revenue. Microeconomics (for MBA students) Dr. F. Fatemi Page 128

12 Oligopoly A market with a few sellers. The essence of an oligopolistic industry is the need for each firm to consider how its own actions affect the decisions of its relatively few competitors. Oligopoly may be characterized by collusion or by non-co-operation: Collusion: an explicit or implicit agreement between existing firms to avoid or limit competition with one another Cartel: is a situation in which formal agreements between firms are legally permitted. e.g. OPEC Microeconomics (for MBA students) Dr. F. Fatemi Page 129

13 Collusion is difficult (reaching agreements to avoid competition) if There are many firms in the industry The product is not standardized Demand and cost conditions are changing rapidly There are no barriers to entry Firms have surplus capacity Microeconomics (for MBA students) Dr. F. Fatemi Page 130

14 The kinked demand curve Consider how a firm may perceive its demand curve under oligopoly. It can observe the current price and output, but must try to anticipate rival reactions to any price change. The firm may expect rivals to respond if it reduces its price, as this will be seen as an aggressive move; so demand in response to a price reduction is likely to be relatively inelastic. but for a price increase rivals are less likely to react, so demand may be relatively elastic above P 0 ; then the firm perceives that it faces a kinked demand curve. Microeconomics (for MBA students) Dr. F. Fatemi Page 131

15 Demand MR1 MR2 MC Given this perception, the firm sees that profit will fall whether price is increased or decreased, so the best strategy is to keep price at P 0 = 40. Price will tend to be stable, even in the face of an increase in marginal cost. Microeconomics (for MBA students) Dr. F. Fatemi Page 132

16 A firm s profit operating in an imperfect competition depend on its own action as well as its rivals actions. That is why we need a different tool to study these situations. That is why we dedicate the next couple of lectures to Game Theory which gives us proper tool for studying economic agents strategic behaviour. Microeconomics (for MBA students) Dr. F. Fatemi Page 133

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