Definition. Is a process by which an individual or a firm predicts future demand for product or products

Demand forecasting

Definition Is a process by which an individual or a firm predicts future demand for product or products Accurate forecasting-enables these firms to produce required quantities at the right time and arrange well in advance for the various factors of production Better planning and allocation of national resources.

Factors Influencing DF How far ahead? Short term Long- term Should forecast be general or specific Problems and methods Classification of goods - consumer - durable - consumer goods and services

Factors Forecasting at different levels Macro Industrial Firm-level

Purposes of forecasting Purposes of short-term forecasting Purposes of long term forecasting

Production scheduling Short-term forecasting Reducing cost of purchasing raw materials Determining appropriate price policy Setting sales targets and establishing controls and incentives Evolving a suitable advertising and promotion programme Forecasting short-term financial

Long-term forecasting Planning of a new unit or expansion of an existing unit Planning of long-term financial requirements Planning of man-power requirements

Criteria for a good forecasting Accuracy Plausibility Simplicity Economy Availability Durability

Methods of demand forecasting Survey or buyer s intention Delphi method Expert opinion Collective opinion Naïve models Smoothing techniques Analysis of time series and trend projections Use of economic indicators Controlled experiments Judgmental approach

There are several methods and techniques available for forecasting demand for a product. All the methods have their own limitations and advantages, merits and demerits, in varying degrees. The applicability and usefulness of a method depends on the purpose of forecasting and availability of reliable and relevant data. The analyst should, therefore, choose a method or a technique of demand forecasting which is relevant to the purpose, convenient to handle, applicable to the available data and also inexpensive.

Survey or buyers method

Direct method of estimating sales in the near future Asking customers what the buyer s are planning to buy Known as opinion survey The burden of forecasting goes to buyer Method is best when bulk of sales is made. Customers may misjudge or mislead or may be uncertain about quantity Not useful in case of house old customers Does not measure and expose the variables under managements control

Methods of demand forecasting Survey methods - experts opinion - consumer survey - complete enumeration - sample survey - end- use - Delphi method

Methods of demand forecasting - market experimentation - stimulated market method - actual market method Statistical method - trend analysis - heading indicator analysis - regression method - simultaneous equation

Survey Methods conducted by sales agencies a direct method of addressing people helps in gaining first hand information

Expert s opinion business firm prefers to depend on survey of experts Experts are those who have the feel about the product opinion poll is conducted among experts Sometimes this method is also called the hunch method

Advantages This method is very easy and less costly to carry out. This method produces quick results When a firm intends to bring a new product, this method is very useful to elicit the opinion of experts on its marketing plans

Disadvantage The experts must have wide knowledge and experience otherwise their opinion may be personal based on guess work. Experts opinion may be biased for a number of reasons.

Consumer survey interviewing the consumers directly to get information about their purchase plans at a number of possible prices over a particular period of time. information collected through questionnaire The data will have to be classified and tabulated for systematic presentation and analysis.

Complete enumeration method/ census method: All consumers of a product are contacted and they are interviewed to know their probable demand for the forecast period. This individual probable demand is added to ascertain the demand forecast for the firm s product. For example there are N consumers, each demanding commodity X, then the total demand forecast would be EN * n. where n=1.

Advantages This method simply records the data and aggregates; it does not introduce any value judgment of his own. The demand forecast through this method is likely to be more accurate than many other methods.

Disadvantages It is time consuming and costly method There can be large number of errors in the data collection, as it is a tedious and cumbersome process.

Sample survey Only few consumers are selected by using some appropriate sampling technique. They are interviewed to ascertain their probable demands for the product for the forecast period. Their average demand is then calculated. This average demand for the sample is multiplied by the total number of consumers to obtain the aggregate demand forecast for the product in question.

Advantages It is a direct method of collecting data from consumers. The information obtained is first hand, it is more reliable. This method saves time, cost and energy. It is economical, if information is collected by postal questionnaire.

Disadvantages There may be sampling error. The smaller the size of the sample, the larger the sampling error. This method provides scope for errors. The consumer may not understand the significance of the questions asked, they may be dishonest, reluctant or shy to reply or they may be either vague or imaginary replies. This reduces the usefulness of information collected.

End-use Method the demand for a product is forecasted through a survey of its users. A product may be used for final consumption by house old sector and government and as an intermediate product by different industries as well as may be exported and imported. purposes can be obtained through a survey of all or selected consumers, exporters and importers and industries using it as an input thus the total demand forecast can be obtained as the sum of the demand forecast of all three components.

Advantages It provides use-wise or sector-wise demand forecasts. This method is used now as a standard tool in economic analysis and are extensively used by governmental and no-governmental agencies.

Disadvantages This method assumes that technical structure of production remains unchanged overtime, which is not true. Because with economic development technical innovations continue to take place and lead to technological changes in the industrial structure. This method needs extensive information on the probable demands of the final goods sector. No company how so ever large can hope to possess this information.

Delphi method In this method an attempt is made to arrive at a consensus in an uncertain area by questioning a group of experts repeatedly until some sort of unanimity is arrived among all experts. These meetings help to narrow down different views of experts.

Advantages In this method it is possible to pose the problem to experts directly It generates a reasonable opinion in place of unstructured opinion. It is a cheap method, save time and resources.

Disadvantages The success of this method depends upon wide knowledge and experience of experts. It could be tedious and costly method if the experts are not too large and are cooperative and forecaster has the necessary funds and ability to perform the task.

Statistical method Time series data: Refers to data collected over a period of time recording historical changes in variables like price, income, etc. that influenced demand for a commodity Time series analysis relate to determination of change in variable in relation to time.

Statistical method Cross sectional :Is undertaken to determine the effect of changes in variables like price, income, etc. on demand for a commodity at a point of item. In cross sectional analysis, different levels of sales among different income groups may be compared at a specific point of time and income elasticity is then estimated on the basis of these differences.

Statistical methods Trend analysis: A firm which has been in existence for a long time will have accumulated data on sales pertaining to different time periods. When such data is arranged, chronologically it is know as Time Series. A typical time series has four components, trend, cyclical fluctuations, seasonal variations and random or irregular fluctuations. This method is highly subjective and considerably depends on the bias of the person drawing the curve. The main advantage of this method is that it does not require the formal knowledge of economic theory and the market, it only needs the time series data.

Regression method involves a study of the dependence of one variable on the other variables. In demand forecasting demand is estimated with the help of a regression equation where in demand is the dependent variable and price, advertising expenditure, consumer s income, etc is the independent variable.

Market Structures

Market In an economic sense, a market is a system by which buyers and sellers bargain for the price of a product, settle the price and transact their business buy and sell a product. Personal contact between the buyers and sellers is not necessary. In some cases, e.g., forward sale and purchase, even immediate transfer of ownership of goods is not necessary. Market does not necessarily mean a place. The market for a commodity may be local, regional, national or international. What makes a market is a set of buyers, a set of sellers and a commodity. While buyers are willing to buy and sellers are willing to sell, and there is a price for the commodity.

Market Structures Type of market structure influences how a firm behaves: Pricing Supply Barriers to Entry Efficiency Competition

Market Structures Degree of competition in the industry High levels of competition Perfect competition Limited competition Monopoly Degrees of competition in between

Market Structure Determinants of market structure Freedom of entry and exit Nature of the product homogenous (identical), differentiated? Control over supply/output Control over price Barriers to entry

Copyright 2004 South-Western The Four Types of Market Structure Number of Firms? Many firms Type of Products? One firm Few firms Differentiated products Identical products Monopoly Oligopoly Monopolistic Competition Perfect Competition Tap water Cable TV Tennis balls Crude oil Novels Movies Wheat Milk

Market Structure Market structure identifies how a market is made up in terms of: The number of firms in the industry The nature of the product produced The degree of monopoly power each firm has The degree to which the firm can influence price Profit levels Firms behaviour pricing strategies, non-price competition, output levels The extent of barriers to entry The impact on efficiency

Market Structure Perfect Competition Pure Monopoly More competitive (fewer imperfections)

Market Structure Perfect Competition Pure Monopoly Less competitive (greater degree of imperfection)

Market Structure Perfect Competition Pure Monopoly Monopolistic Competition Oligopoly Duopoly Monopoly The further right on the scale, the greater the degree of monopoly power exercised by the firm.

Market Structure Importance: Degree of competition affects the consumer will it benefit the consumer or not? Impacts on the performance and behaviour of the company/companies involved

Market Structure Characteristics of each model: Number and size of firms that make up the industry Control over price or output Freedom of entry and exit from the industry Nature of the product degree of homogeneity (similarity) of the products in the industry (extent to which products can be regarded as substitutes for each other) Diagrammatic representation the shape of the demand curve, etc.

Market Structure Characteristics: Look at these everyday products what type of market structure are the producers of these products operating in? Canon SLR Camera Remember to think about the nature of the product, entry and exit, behaviour of the firms, number and size of the firms in the industry. You might even have to ask what the industry is?? Bananas

Perfect Competition One extreme of the market structure spectrum Characteristics: Large number of firms Products are homogenous (identical) consumer has no reason to express a preference for any firm Freedom of entry and exit into and out of the industry Firms are price takers have no control over the price they charge for their product Each producer supplies a very small proportion of total industry output Consumers and producers have perfect knowledge about the market

Monopolistic or Imperfect Competition Where the conditions of perfect competition do not hold, imperfect competition will exist Varying degrees of imperfection give rise to varying market structures Monopolistic competition is one of these not to be confused with monopoly!

Monopolistic or Imperfect Competition Characteristics: Large number of firms in the industry May have some element of control over price due to the fact that they are able to differentiate their product in some way from their rivals products are therefore close, but not perfect, substitutes Entry and exit from the industry is relatively easy few barriers to entry and exit Consumer and producer knowledge imperfect

Monopolistic or Imperfect Competition Some important points about monopolistic competition: May reflect a wide range of markets Not just one point on a scale reflects many degrees of imperfection

Monopolistic or Imperfect Competition Restaurants Plumbers/electricians/local builders Solicitors Private schools Plant hire firms Insurance brokers Health clubs Hairdressers Funeral directors Estate agents Damp proofing control firms

Market Structure Perfect Competition: Free entry and exit to industry Homogenous product identical so no consumer preference Large number of buyers and sellers no individual seller can influence price Sellers are price takers have to accept the market price Perfect information available to buyers and sellers

Market Structure Examples of perfect competition: Financial markets stock exchange, currency markets, bond markets? Agriculture? To what extent?

Market Structure Advantages of Perfect Competition: High degree of competition helps allocate resources to most efficient use Price = marginal costs Normal profit made in the long run Firms operate at maximum efficiency Consumers benefit

Market Structure What happens in a competitive environment? New idea? firm makes short term abnormal profit Other firms enter the industry to take advantage of abnormal profit Supply increases price falls Long run normal profit made Choice for consumer Price sufficient for normal profit to be made but no more!

Market Structure Imperfect or Monopolistic Competition Many buyers and sellers Products differentiated Relatively free entry and exit Each firm may have a tiny monopoly because of the differentiation of their product Firm has some control over price Examples restaurants, professions solicitors, etc., building firms plasterers, plumbers, etc.

Monopolistic Competition Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly.

Monopolistic Competition Types of Imperfectly Competitive Markets Monopolistic Competition Many firms selling products that are similar but not identical. Oligopoly Only a few sellers, each offering a similar or identical product to the others.

Monopolistic Competition Markets that have some features of competition and some features of monopoly.

Monopolistic Competition Attributes of Monopolistic Competition Many sellers Product differentiation Free entry and exit

Monopolistic Competition Many Sellers There are many firms competing for the same group of customers. Product examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc.

Monopolistic Competition Product Differentiation Each firm produces a product that is at least slightly different from those of other firms. Rather than being a price taker, each firm faces a downward-sloping demand curve.

Monopolistic Competition Free Entry or Exit Firms can enter or exit the market without restriction. The number of firms in the market adjusts until economic profits are zero.

COMPETITION WITH DIFFERENTIATED PRODUCTS The Monopolistically Competitive Firm in the Short Run Short-run economic profits encourage new firms to enter the market. This: Increases the number of products offered. Reduces demand faced by firms already in the market. Incumbent firms demand curves shift to the left. Demand for the incumbent firms products fall, and their profits decline.

COMPETITION WITH DIFFERENTIATED PRODUCTS The Monopolistically Competitive Firm in the Short Run Short-run economic losses encourage firms to exit the market. This: Decreases the number of products offered. Increases demand faced by the remaining firms. Shifts the remaining firms demand curves to the right. Increases the remaining firms profits.

Figure 1 Monopolistic Competitors in the Short Run Price (b) Firm Makes Losses Losses MC ATC Average total cost Price MR Demand 0 Lossminimizing quantity Quantity Copyright 2003 Southwestern/Thomson Learning

The Long-Run Equilibrium Firms will enter and exit until the firms are making exactly zero economic profits.

Long-Run Equilibrium Two Characteristics As in a monopoly, price exceeds marginal cost. Profit maximization requires marginal revenue to equal marginal cost. The downward-sloping demand curve makes marginal revenue less than price. As in a competitive market, price equals average total cost. Free entry and exit drive economic profit to zero.

Monopolistic versus Perfect Competition There are two noteworthy differences between monopolistic and perfect competition excess capacity and markup.

Monopolistic versus Perfect Competition Excess Capacity There is no excess capacity in perfect competition in the long run. Free entry results in competitive firms producing at the point where average total cost is minimized, which is the efficient scale of the firm. There is excess capacity in monopolistic competition in the long run. In monopolistic competition, output is less than the efficient scale of perfect competition.

Copyright 2003 Southwestern/Thomson Learning Figure 3 Monopolistic versus Perfect Competition (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Price Price MC ATC MC ATC P P = MC P = MR (demand curve) MR Demand 0 Quantity produced Efficient scale Quantity 0 Quantity produced = Efficient scale Quantity

Monopolistic versus Perfect Competition Markup Over Marginal Cost For a competitive firm, price equals marginal cost. For a monopolistically competitive firm, price exceeds marginal cost. Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically competitive firm.

Copyright 2003 Southwestern/Thomson Learning Figure 3 Monopolistic versus Perfect Competition (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Price Price MC ATC MC ATC Markup P Marginal cost MR Demand P = MC P = MR (demand curve) 0 Quantity produced Quantity 0 Quantity produced Quantity

Copyright 2003 Southwestern/Thomson Learning Figure 3 Monopolistic versus Perfect Competition (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Price Price MC ATC MC ATC Markup P Marginal cost MR Demand P = MC P = MR (demand curve) 0 Quantity produced Efficient scale Quantity 0 Quantity produced = Efficient scale Quantity Excess capacity

Monopolistic Competition and the Welfare of Society Monopolistic competition does not have all the desirable properties of perfect competition.

Monopolistic Competition and the Welfare of Society There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost. However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.

Monopolistic Competition and the Welfare of Society Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the ideal one. There may be too much or too little entry.

Monopolistic Competition and the Welfare of Society Externalities of entry include: product-variety externalities. business-stealing externalities.

Monopolistic Competition and the Welfare of Society The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers. 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.

ADVERTISING When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product.

ADVERTISING Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue on advertising. Overall, about 2 percent of total revenue, or over $200 billion a year, is spent on advertising.

ADVERTISING Critics of advertising argue that firms advertise in order to manipulate people s tastes. They also argue that it impedes competition by implying that products are more different than they truly are.

ADVERTISING Defenders argue that advertising provides information to consumers They also argue that advertising increases competition by offering a greater variety of products and prices. The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.

Brand Names Critics argue that brand names cause consumers to perceive differences that do not really exist.

Brand Names Economists have argued that brand names may be a useful way for consumers to ensure that the goods they are buying are of high quality. providing information about quality. giving firms incentive to maintain high quality.

Summary A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry. The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost.

Summary Monopolistic competition does not have all of the desirable properties of perfect competition. There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost. The number of firms can be too large or too small.

Summary The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names. Critics argue that firms use advertising and brand names to take advantage of consumer irrationality and to reduce competition. Defenders argue that firms use advertising and brand names to inform consumers and to compete more vigorously on price and product quality.

Market Structure Oligopoly Competition amongst the few Industry dominated by small number of large firms Many firms may make up the industry High barriers to entry Products could be highly differentiated branding or homogenous Non price competition Price stability within the market - kinked demand curve? Potential for collusion? Abnormal profits High degree of interdependence between firms

Market Structure Examples of oligopolistic structures: Supermarkets Banking industry Chemicals Oil Medicinal drugs Broadcasting

Market Structure Measuring Oligopoly: Concentration ratio the proportion of market share accounted for by top X number of firms: E.g. 5 firm concentration ratio of 80% - means top 5 five firms account for 80% of market share 3 firm CR of 72% - top 3 firms account for 72% of market share

Market Structure Duopoly: Industry dominated by two large firms Possibility of price leader emerging rival will follow price leaders pricing decisions High barriers to entry Abnormal profits likely

Market Structure Monopoly: Pure monopoly industry is the firm! Actual monopoly where firm has >25% market share Natural Monopoly high fixed costs gas, electricity, water, telecommunications, rail

BETWEEN MONOPOLY AND PERFECT COMPETITION Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly.

BETWEEN MONOPOLY AND PERFECT COMPETITION Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.

BETWEEN MONOPOLY AND PERFECT COMPETITION Types of Imperfectly Competitive Markets Oligopoly Only a few sellers, each offering a similar or identical product to the others. Monopolistic Competition Many firms selling products that are similar but not identical.

Copyright 2004 South-Western Figure 1 The Four Types of Market Structure Number of Firms? Many firms Type of Products? One firm Few firms Differentiated products Identical products Monopoly Oligopoly Monopolistic Competition Perfect Competition Tap water Cable TV Tennis balls Crude oil Novels Movies Wheat Milk

MARKETS WITH ONLY A FEW SELLERS Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest.

MARKETS WITH ONLY A FEW SELLERS Characteristics of an Oligopoly Market Few sellers offering similar or identical products Interdependent firms Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost

A Duopoly Example A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.

Competition, Monopolies, and Cartels The duopolists may agree on a monopoly outcome. Collusion An agreement among firms in a market about quantities to produce or prices to charge. Cartel A group of firms acting in unison.

Competition, Monopolies, and Cartels Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.

The Equilibrium for an Oligopoly A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

The Equilibrium for an Oligopoly When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition.

The Equilibrium for an Oligopoly The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

Equilibrium for an Oligopoly Summary Possible outcome if oligopoly firms pursue their own self-interests: Joint output is greater than the monopoly quantity but less than the competitive industry quantity. Market prices are lower than monopoly price but greater than competitive price. Total profits are less than the monopoly profit.

GAME THEORY AND THE ECONOMICS OF COOPERATION Game theory is the study of how people behave in strategic situations. Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

GAME THEORY AND THE ECONOMICS OF COOPERATION Because the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce.

The Prisoners Dilemma The prisoners dilemma provides insight into the difficulty in maintaining cooperation. Often people (firms) fail to cooperate with one another even when cooperation would make them better off.

The Prisoners Dilemma The prisoners dilemma is a particular game between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

Copyright 2003 Southwestern/Thomson Learning Figure 2 The Prisoners Dilemma Bonnie s Decision Confess Bonnie gets 8 years Remain Silent Bonnie gets 20 years Confess Clyde s Decision Clyde gets 8 years Bonnie goes free Clyde goes free Bonnie gets 1 year Remain Silent Clyde gets 20 years Clyde gets 1 year

The Prisoners Dilemma The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.

The Prisoners Dilemma Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

Copyright 2003 Southwestern/Thomson Learning Figure 3 An Oligopoly Game Iraq s Decision High Production Iraq gets $40 billion Low Production Iraq gets $30 billion Iran s Decision High Production Low Production Iran gets $40 billion Iraq gets $60 billion Iran gets $30 billion Iran gets $60 billion Iraq gets $50 billion Iran gets $50 billion

Oligopolies as a Prisoners Dilemma Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits.

Copyright 2003 Southwestern/Thomson Learning Figure 4 An Arms-Race Game Decision of the United States (U.S.) Arm Disarm U.S. at risk U.S. at risk and weak Arm Decision of the Soviet Union (USSR) USSR at risk U.S. safe and powerful USSR safe and powerful U.S. safe Disarm USSR at risk and weak USSR safe

Copyright 2003 Southwestern/Thomson Learning Figure 5 An Advertising Game Marlboro s Decision Camel s Decision Advertise Don t Advertise Advertise Camel gets $3 billion profit Camel gets $2 billion profit Marlboro gets $3 billion profit Marlboro gets $5 billion profit Don t Advertise Camel gets $5 billion profit Camel gets $4 billion profit Marlboro gets $2 billion profit Marlboro gets $4 billion profit

Figure 6 A Common-Resource Game Exxon s Decision Drill Two Wells Drill One Well Texaco s Decision Drill Two Wells Drill One Well Texaco gets $4 million profit Texaco gets $3 million profit Exxon gets $4 million profit Exxon gets $6 million profit Texaco gets $6 million profit Texaco gets $5 million profit Exxon gets $3 million profit Exxon gets $5 million profit Copyright 2003 Southwestern/Thomson Learning

Why People Sometimes Cooperate Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a onetime gain.

Copyright 2003 Southwestern/Thomson Learning Figure 7 Jack and Jill Oligopoly Game Jack s Decision Sell 40 Gallons Sell 30 Gallons Jill s Decision Sell 40 Gallons Sell 30 Gallons Jill gets $1,600 profit Jill gets $1,500 profit Jack gets $1,600 profit Jack gets $2,000 profit Jill gets $2,000 profit Jill gets $1,800 profit Jack gets $1,500 profit Jack gets $1,800 profit

PUBLIC POLICY TOWARD OLIGOPOLIES Cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too low and prices that are too high.

Restraint of Trade and the Antitrust Laws Antitrust laws make it illegal to restrain trade or attempt to monopolize a market. Sherman Antitrust Act of 1890 Clayton Act of 1914

Controversies over Antitrust Policy Antitrust policies sometimes may not allow business practices that have potentially positive effects: Resale price maintenance Predatory pricing Tying

Controversies over Antitrust Policy Resale Price Maintenance (or fair trade) occurs when suppliers (like wholesalers) require retailers to charge a specific amount Predatory Pricing occurs when a large firm begins to cut the price of its product(s) with the intent of driving its competitor(s) out of the market Tying when a firm offers two (or more) of its products together at a single price, rather than separately

Summary Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. If oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome.

Summary The prisoners dilemma shows that selfinterest can prevent people from maintaining cooperation, even when cooperation is in their mutual self-interest. The logic of the prisoners dilemma applies in many situations, including oligopolies.

Summary Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition.

Market Structure Monopoly: High barriers to entry Firm controls price OR output/supply Abnormal profits in long run Possibility of price discrimination Consumer choice limited Prices in excess of MC

While a competitive firm is a price taker, a monopoly firm is a price maker.

A firm is considered a monopoly if... it is the sole seller of its product. its product does not have close substitutes.

WHY MONOPOLIES ARISE The fundamental cause of monopoly is barriers to entry.

WHY MONOPOLIES ARISE Barriers to entry have three sources: Ownership of a key resource. The government gives a single firm the exclusive right to produce some good. Costs of production make a single producer more efficient than a large number of producers.

Monopoly Resources Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason.

Government-Created Monopolies Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets.

Government-Created Monopolies Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest.

Natural Monopolies An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.

Natural Monopolies A natural monopoly arises when there are economies of scale over the relevant range of output.

HOW MONOPOLIES MAKE PRODUCTION AND PRICING DECISIONS Monopoly versus Competition Monopoly Is the sole producer Faces a downward-sloping demand curve Is a price maker Reduces price to increase sales Competitive Firm Is one of many producers Faces a horizontal demand curve Is a price taker Sells as much or as little at same price

Copyright 2004 South-Western Figure 2 Demand Curves for Competitive and Monopoly Firms (a) A Competitive Firm s Demand Curve (b) A Monopolist s Demand Curve Price Price Demand Demand 0 Quantity of Output 0 Quantity of Output

A Monopoly s Revenue A Monopoly s Marginal Revenue A monopolist s marginal revenue is always less than the price of its good. The demand curve is downward sloping. When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases.

A Monopoly s Revenue A Monopoly s Marginal Revenue When a monopoly increases the amount it sells, it has two effects on total revenue (P Q). The output effect more output is sold, so Q is higher. The price effect price falls, so P is lower.

Copyright 2004 South-Western Figure 3 Demand and Marginal-Revenue Curves for a Monopoly Price $11 10 9 8 7 6 5 4 3 2 1 0 1 2 3 4 Marginal revenue 1 2 3 4 5 6 7 8 Demand (average revenue) Quantity of Water

Profit Maximization A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. It then uses the demand curve to find the price that will induce consumers to buy that quantity.

Copyright 2004 South-Western Figure 4 Profit Maximization for a Monopoly Costs and Revenue Monopoly price 2.... and then the demand curve shows the price consistent with this quantity. B 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity... A Average total cost Marginal cost Demand Marginal revenue 0 Q Q MAX Q Quantity

Profit Maximization Comparing Monopoly and Competition For a competitive firm, price equals marginal cost. P = MR = MC For a monopoly firm, price exceeds marginal cost. P > MR = MC

A Monopoly s Profit Profit equals total revenue minus total costs. Profit = TR - TC Profit = (TR/Q - TC/Q) Q Profit = (P - ATC) Q

Copyright 2004 South-Western Figure 5 The Monopolist s Profit Costs and Revenue Marginal cost Monopoly price E B Monopoly profit Average total cost Average total cost D C Demand Marginal revenue 0 Q MAX Quantity

A Monopolist s Profit The monopolist will receive economic profits as long as price is greater than average total cost.

Copyright 2004 South-Western Figure 6 The Market for Drugs Costs and Revenue Price during patent life Price after patent expires Marginal revenue Demand Marginal cost 0 Monopoly quantity Competitive quantity Quantity

THE WELFARE COST OF MONOPOLY In contrast to a competitive firm, the monopoly charges a price above the marginal cost. From the standpoint of consumers, this high price makes monopoly undesirable. However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable.

Copyright 2004 South-Western Figure 7 The Efficient Level of Output Price Marginal cost Value to buyers Cost to monopolist Cost to monopolist Value to buyers Demand (value to buyers) 0 Quantity Value to buyers is greater than cost to seller. Efficient quantity Value to buyers is less than cost to seller.

The Deadweight Loss Because a monopoly sets its price above marginal cost, it places a wedge between the consumer s willingness to pay and the producer s cost. This wedge causes the quantity sold to fall short of the social optimum.

The Deadweight Loss The Inefficiency of Monopoly The monopolist produces less than the socially efficient quantity of output.

The Deadweight Loss The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax. The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit.

PUBLIC POLICY TOWARD MONOPOLIES Government responds to the problem of monopoly in one of four ways. Making monopolized industries more competitive. Regulating the behavior of monopolies. Turning some private monopolies into public enterprises. Doing nothing at all.

Increasing Competition with Antitrust Laws Antitrust laws are a collection of statutes aimed at curbing monopoly power. Antitrust laws give government various ways to promote competition. They allow government to prevent mergers. They allow government to break up companies. They prevent companies from performing activities that make markets less competitive.

Increasing Competition with Antitrust Laws Two Important Antitrust Laws Sherman Antitrust Act (1890) Reduced the market power of the large and powerful trusts of that time period. Clayton Act (1914) Strengthened the government s powers and authorized private lawsuits.

Regulation Government may regulate the prices that the monopoly charges. The allocation of resources will be efficient if price is set to equal marginal cost.

Regulation In practice, regulators will allow monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing.

Public Ownership Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself (e.g. in the United States, the government runs the Postal Service).

Doing Nothing Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies.

PRICE DISCRIMINATION Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.

PRICE DISCRIMINATION Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power. Perfect Price Discrimination Perfect price discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.

PRICE DISCRIMINATION Two important effects of price discrimination: It can increase the monopolist s profits. It can reduce deadweight loss.

Copyright 2004 South-Western Figure 10 Welfare with and without Price Discrimination (a) Monopolist with Single Price Price Monopoly price Profit Consumer surplus Deadweight loss Marginal cost Marginal revenue Demand 0 Quantity sold Quantity

PRICE DISCRIMINATION Examples of Price Discrimination Movie tickets Airline prices Discount coupons Financial aid Quantity discounts

CONCLUSION: THE PREVALENCE OF MONOPOLY How prevalent are the problems of monopolies? Monopolies are common. Most firms have some control over their prices because of differentiated products. Firms with substantial monopoly power are rare. Few goods are truly unique.

Summary A monopoly is a firm that is the sole seller in its market. It faces a downward-sloping demand curve for its product. A monopoly s marginal revenue is always below the price of its good.

Summary Like a competitive firm, a monopoly maximizes profit by producing the quantity at which marginal cost and marginal revenue are equal. Unlike a competitive firm, its price exceeds its marginal revenue, so its price exceeds marginal cost.

Summary A monopolist s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus. A monopoly causes deadweight losses similar to the deadweight losses caused by taxes.

Summary Policymakers can respond to the inefficiencies of monopoly behavior with antitrust laws, regulation of prices, or by turning the monopoly into a government-run enterprise. If the market failure is deemed small, policymakers may decide to do nothing at all.

Summary Monopolists can raise their profits by charging different prices to different buyers based on their willingness to pay. Price discrimination can raise economic welfare and lessen deadweight losses.

Market Structure Advantages and disadvantages of monopoly: Advantages: May be appropriate if natural monopoly Encourages R&D Encourages innovation Development of some products not likely without some guarantee of monopoly in production Economies of scale can be gained consumer may benefit

Market Structure Disadvantages: Exploitation of consumer higher prices Potential for supply to be limited - less choice Potential for inefficiency X-inefficiency complacency controls on costs over

Market Structure Price Kinked Demand Curve 5 Kinked D Curve D = Inelastic D = elastic 100 Quantity

Monopolistic or Imperfect Competition In each case there are many firms in the industry Each can try to differentiate its product in some way Entry and exit to the industry is relatively free Consumers and producers do not have perfect knowledge of the market the market may indeed be relatively localised. Can you imagine trying to search out the details, prices, reliability, quality of service, etc for every plumber in the UK in the event of an emergency??

Oligopoly Competition between the few May be a large number of firms in the industry but the industry is dominated by a small number of very large producers Concentration Ratio the proportion of total market sales (share) held by the top 3,4,5, etc firms: A 4 firm concentration ratio of 75% means the top 4 firms account for 75% of all the sales in the industry

Oligopoly Example: Music sales The music industry has a 5-firm concentration ratio of 75%. Independents make up 25% of the market but there could be many thousands of firms that make up this independents group. An oligopolistic market structure therefore may have many firms in the industry but it is dominated by a few large sellers. Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html

Oligopoly Features of an oligopolistic market structure: Price may be relatively stable across the industry kinked demand curve? Potential for collusion Behaviour of firms affected by what they believe their rivals might do interdependence of firms Goods could be homogenous or highly differentiated Branding and brand loyalty may be a potent source of competitive advantage Non-price competition may be prevalent Game theory can be used to explain some behaviour AC curve may be saucer shaped minimum efficient scale could occur over large range of output High barriers to entry

Oligopoly Price The kinked demand curve - an explanation for price stability? 5 Total Revenue B Total Revenue A Total Revenue B Assume If The the firm principle therefore, seeks firm of to is the lower effectively charging kinked its price demand a faces price to of 5 gain a kinked and a curve competitive producing demand rests on an curve advantage, the output principle forcing of 100. its it rivals to will maintain follow that: a suit. stable Any or gains rigid pricing it makes will If it chose to raise price above 5, its quickly structure. be Oligopolistic lost and the firms % change may in rivals a. would If a firm not raises follow its suit price, and its the firm demand overcome will this be by smaller engaging than in the nonprice competition. in price total revenue % effectively rivals faces will not an follow elastic suit demand reduction curve for its product (consumers would would b. If again a firm fall lowers as the its firm price, now its faces buy from the cheaper rivals). The % a relatively rivals inelastic will all do demand the same curve. change in demand would be greater than the % change in price and TR would fall. Kinked D Curve D = Inelastic D = elastic 100 Quantity

Duopoly Market structure where the industry is dominated by two large producers Collusion may be a possible feature Price leadership by the larger of the two firms may exist the smaller firm follows the price lead of the larger one Highly interdependent High barriers to entry Cournot Model French economist analysed duopoly suggested long run equilibrium would see equal market share and normal profit made In reality, local duopolies may exist

Monopoly Pure monopoly where only one producer exists in the industry In reality, rarely exists always some form of substitute available! Monopoly exists, therefore, where one firm dominates the market Firms may be investigated for examples of monopoly power when market share exceeds 25% Use term monopoly power with care!

Monopoly Monopoly power refers to cases where firms influence the market in some way through their behaviour determined by the degree of concentration in the industry Influencing prices Influencing output Erecting barriers to entry Pricing strategies to prevent or stifle competition May not pursue profit maximisation encourages unwanted entrants to the market Sometimes seen as a case of market failure

Monopoly Origins of monopoly: Through growth of the firm Through amalgamation, merger or takeover Through acquiring patent or license Through legal means Royal charter, nationalisation, wholly owned plc

Monopoly Summary of characteristics of firms exercising monopoly power: Price could be deemed too high, may be set to destroy competition (destroyer or predatory pricing), price discrimination possible. Efficiency could be inefficient due to lack of competition (X- inefficiency) or could be higher due to availability of high profits

Monopoly Innovation - could be high because of the promise of high profits, Possibly encourages high investment in research and development (R&D) Collusion possible to maintain monopoly power of key firms in industry High levels of branding, advertising and non-price competition

Monopoly Problems with models a reminder: Often difficult to distinguish between a monopoly and an oligopoly both may exhibit behaviour that reflects monopoly power Monopolies and oligopolies do not necessarily aim for traditional assumption of profit maximisation Degree of contestability of the market may influence behaviour Monopolies not always bad may be desirable in some cases but may need strong regulation Monopolies do not have to be big could exist locally

Monopoly Costs / Revenue 7.00 Monopoly Profit MC AC AR Given This (D) is the both curve barriers the for short a to monopolist entry, run and likely the long monopolist run to be equilibrium relatively will be position price able to inelastic. exploit for a monopoly abnormal Output assumed profits in the to be long at run profit as maximising entry to the output (note market caution is restricted. here not all monopolists may aim for profit maximisation!) 3.00 Q1 MR AR Output / Sales

Costs / Revenue 7 3 Loss of consumer surplus Monopoly MC AC Welfare implications of monopolies The A look higher price monopoly back in price at a competitive the price and diagram lower would be for output perfect market 7 per means unit competition would with that be output 3 consumer will with levels reveal surplus that output lower in at is equilibrium, levels Q2. reduced, at Q1. indicated price will by be the equal grey to shaded the MC area. of production. On the face of it, consumers We face can higher look prices therefore and at less a comparison choice in monopoly of the differences conditions between compared price to more and competitive output in a competitive environments. situation compared to a monopoly. Q2 MR Q1 AR Output / Sales