Lecture 11 Imperfect Competition Business 5017 Managerial Economics Kam Yu Fall 2013
Outline 1 Introduction 2 Monopolistic Competition 3 Oligopoly Modelling Reality The Stackelberg Leadership Model Collusion Regulating Monopoly 4 Business Regulation Public Interest Theory Economic Theory of Regulation 5 Market for Corporate Control Firm Integrations Are Hostile Takeovers Efficient? Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 2 / 29
Introduction Monopolistic Competition and Oligopoly We have so far studied two extreme forms of market structure. In perfect competition, no single firm has the market power to influence the market price. In the long run firms make no economic profit. A monopolist which sells a product with no close substitute enjoy great market power and makes economic profits in the long run. Most market structures in our economy are something in between. In monopolistic competition, each firm sells a differentiated product with its market niche. The firms enjoy some market power and face their own downward sloping demand curves. In an oligopoly, price, quantity, and therefore profits depend on the interactions of the firm. The form of competition and market outcome are indeterminate. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 3 / 29
Monopolistic Competition Market Power The market power of a monopolistic competitive firm depends on a number of factors: Number of competitors Production capacity of competitors Ease of new firms entering the market Degree of product differentiation Brand name recognition and loyalty Price difference awareness of consumers Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 4 / 29
Monopolistic Competition Short-Run Competition A typical firm faces a downward sloping demand curve, with a steeper marginal revenue curve. Profit maximization is achieved by setting MC = MR. The firm produces Q mc and charges P mc on the demand curve. Economic inefficiency compared with the perfectly competitive market. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 5 / 29
Monopolistic Competition Long-Run Competition As long as the firms are making economic profits, new firms will enter the market. The demand and MR curves of a typical firm shift down because of increased competitive. Demand also becomes more elastic. This continues until all economic profits have eroded, with price P mc1 and quantity Q mc1 on the LRAC curve. Note that in the long run the firm is not producing at the minimum efficiency scale, meaning economic inefficiency. This occurs as long as the demand curve facing an individual firm is not perfectly elastic. Firms in monopolistic competitive often engage in non-price competitive such as advertisement and customer relationships. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 6 / 29
Long-Run Profits Monopolistic Competition Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 7 / 29
Oligopoly Modelling Reality Just a Handful of Sellers Typically just a few sellers in a market with not much product differentiation. Barriers to entry are high. Demands are more inelastic than that in a monopolistic competition. Therefore the oligopolists have more market power. Consequently if an oligopolist behaves like a monopolist, the dead-weight loss is larger than that of a monopolistic competitive firm. However, this is not always the case. Pricing decisions of oligopolists are mutually interdependent. There is a wide variety of economic models on their behaviours. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 8 / 29
Oligopoly Oligopolist as a Monopolist Modelling Reality Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 9 / 29
Oligopoly The Stackelberg Leadership Model One Market Leader The market is dominated by one big producer with cost advantage (advanced technology, patents, big brand name, etc.). The rest of the firms are followers with no market power. The total supply curve of the followers is the sum of their MC curves. Without the leader, this supply curve MC c meets the market demand curve D m at price P 1 and quantity Q 2. Excess demand exists at any price below P 1, these excess demands become the demand curve D d for the dominant producer, with corresponding marginal revenue MR d. The dominant producer maximizes profit by setting MC = MR with the price-quantity combination (P d, Q d ). The followers are price takers, now face market price P d. The excess demand between the consumers and the followers is Q 3 Q 1, which is equal to Q d. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 10 / 29
Oligopoly Price Leader and Followers The Stackelberg Leadership Model Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 11 / 29
Oligopoly Collusion How Cartels are Formed If product differentiation is weak, consumers are more price sensitive. Pricing becomes the main tool in competition among the oligopolists. There are strong incentives for the firm to form a cartel and behave collectively like a monopoly. The cartel chooses the monopoly price-quantity combination to maximize profit, which is shared by its members. With the high monopoly price, however, each individual firm in the cartel has an incentive to cheat, making even more profit by increasing production. To avoid collapse, the cartel must have a mechanism in place to punish the cheaters. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 12 / 29
Oligopoly Collusion An Example of Duopoly Two identical firms with constant returns to scale technology. They form a cartel to maximize joint profit with (P m, Q m ). This means each firm produces at a level Q 1 = Q m /2. After the collusion agreement, each firm has the incentive to lower price a little to P 1 and capture almost the whole monopoly market. But total profit goes down if both cheat. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 13 / 29
Oligopoly Collusion Back to Game Theory The above colluding duopoly can be described by a Prisoner s Dilemma model. Assume that the two firms, A and B, have two choices, high price or low price. Their incentive can be analyzed with the payoff matrix. For Firm A, no matter what Firm B chooses, its best strategy is to choose low price. The same is true for Firm B. Therefore the dominant strategy is low price for both firms, resulting in the inefficient outcome (500, 500). This outcome is also a Nash equilibrium, which consists of the best strategy for every player given the action of all the other players. In other words, no player has the incentive to change his/her choice. Therefore in a one-shot game the collusion will fail. In a repeated game setting, the behaviours are more complicated. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 14 / 29
Oligopoly Payoff Matrix of a Duopoly Collusion Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 15 / 29
Oligopoly Collusion Cartels with Lagged Demand Recall that when a product exhibits lagged demand due to network effect or rational addiction, a firm has the incentive to lower price now so that demand will be higher in the future. This applies to a cartel as well. But individual firm has the incentive to free-ride the other firms. Since the game is inherently dynamic, actual behaviours depends on the mechanism design of the cartel. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 16 / 29
Oligopoly Collusion Government-Supported Cartels In a lot of cases the transaction costs of maintaining a cartel (negotiating, monitoring, and enforcing the agreement) is higher than the benefits of collusion. The problem may be resolved with a third party doing the monitoring and enforcement task. A good candidate for this third party is the government. With legislative and executive power, the government can be very efficient in maintaining a cartel. This is why some industries lobby for government regulations or oppose deregulation. The effects of regulations can suppress competition. Examples: airline regulations, liquor licence, banning Sunday shopping, professional licensing, etc. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 17 / 29
Natural Monopoly Oligopoly Regulating Monopoly When the long-run average cost is declining within the range of market demand, it is cost effective to have a single producer. The natural monopoly is socially inefficient, however, if it exploits consumers with its market power. The government usually steps in to regulate the monopoly. Instead of the monopolist s profit maximizing (P m, Q m ), the government can impose a price ceiling at P 1, where the LRAC meets the market demand curve. This may occur naturally without government intervention in a contestable market. Even though there is a high fixed cost, some well-financed firms may see the monopoly profit as a sign to enter the market. The threat of a price war with a new competitor keeps the natural monopolist in check and charge a price close to the socially efficient level at P 1. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 18 / 29
A Natural Monopolist Oligopoly Regulating Monopoly Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 19 / 29
Business Regulation Public Interest Theory The Government is the Problem Many sectors in the economy are subject to various degree of government regulation. In Canada the most heavily regulated sectors are health care, education, transportation, telecommunication, agriculture, and electricity. Common reasons for regulation are social insurance, monopoly power, public safety, market stability, preservation of culture and languages, etc. Some economists think that excessive government regulation hinders the operation of the free markets and creates inefficiency. Others try to explain regulation from an institutional economics perspective. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 20 / 29
Business Regulation Public Interest Theory Regulating Cartels and Natural Monopoly Cartels and natural monopoly are common targets by government. The objective is to eliminate the dead-weight welfare loss in the industry. Determining the exact values of the socially efficient price-quantity combination (P c, Q c ), however, is not a trivial task. Cost structure of a monopolist is private to the firm. It has the incentive to mislead the government. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 21 / 29
Business Regulation Public Interest Theory Subsidizing a Monopoly In some cases even the monopoly does not exploit the consumers and produces at the output level that price equals LRAC, it is still not socially efficient. This is because LRAC is declining so that LRMC is below it. Consumers willingness to pay at the margin is still higher than the marginal cost of production. To induce the monopolist to produce at the socially efficient output Q 2, the government can provide a subsidy to the firm equals to the economic losses. This, however, gives the incentive to the managers to turn the subsidy into perks and increased pays. Unions members of the firm have the incentives to negotiate pay raise and more fringe benefits. LRAC and LRMC will shift upward, raising market price and reducing output. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 22 / 29
Business Regulation Public Interest Theory Underproduction and Government Subsidy Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 23 / 29
Business Regulation Economic Theory of Regulation Regulation as a Marketable Product The provision of government regulation can be viewed as a market service, subject to the forces of supply and demand. On the supply side: benefits include campaign contributions, lucrative consulting jobs, or sometimes outright bribery. On the demand side: Monitoring and enforcing cartel agreements to prevent competition Erecting barriers to entry and establishing import restrictions Providing subsidies Preventing deregulation Free-riding problems exist when the industry is big and diverse. The economic theory of regulation provides a useful conceptual framework but is less successful in predicting the outcomes of specific industries. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 24 / 29
Market for Corporate Control Firm Integrations Mergers, Acquisitions, and Hostile Takeover The economic theory of market can be applied to consumer or industrial goods and services and provision of government regulation. It can also be applied to the market of corporate control. Firms can be bought and sold as investment vehicles. When firms change hand under friendly agreements, it is called as mergers (TD Bank and Canada Trust) or acquisitions (Walmart Canada buying stores from Zellers). Economists classify M&A as horizontal or vertical integrations. Occasionally corporate raiders offer a deal directly to shareholders without management s approval. These are labelled as hostile takeover. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 25 / 29
Market for Corporate Control Firm Integrations Managerial Monopolies Internal departments of a firm can behave like a monopoly, restricting services and requiring larger budget of operations. Management uses outsourcing as a tool to avoid inefficiency of internal monopolies. If the management is unable or unwilling to tackle these inefficiency, the company s stock value may become depressed. This provides incentive for an outside to take over the firm, improve its efficiency, and resell it at a profit. The threat of a hostile takeover keeps internal monopolistic behaviours in check. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 26 / 29
Market for Corporate Control Firm Integrations Hostile Takeover and Principal-Agent Problem In a classical principal-agent situation, the objective of the management of a firm is not aligned with that of the shareholders. In a hostile takeover, the management always oppose the firm being taken over. The new owner of the firm threatens their pay, perks, and privileges. Often the management team will be replaced. The shareholders of the target firm, on the other hand, are the main beneficiaries of the takeover. They see their stock prices go up about 50 percent. Following this argument, a hostile takeover bid is usually a signal that the target firm suffers from principal-agent problems. Outsiders see the opportunity to improve the operation of the firm. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 27 / 29
Market for Corporate Control Are Hostile Takeovers Efficient? Cost-Benefit Analysis of Takeovers The shareholders of the target firm usually gain from a hostile takeover. What about the other players? Winner s curse Imagine that bidders of a firm have their own subjective evaluation on the value of the target firm. The one which wins the bid has the most optimistic outlook. The winning firm may overbid compared with the average bid. This may potential hurt the shareholders of the acquiring firm. Empirical studies do not support this argument, shareholders of the acquiring firm on the average gain 1 to 3 percent in their stock prices. Firms which actually suffer the winer s curse, however, are more likely to become the target of hostile takeovers themselves. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 28 / 29
Market for Corporate Control Are Hostile Takeovers Efficient? Other Third Parties Bondholders A hostile takeover may increase the risk the target firms or the acquiring firm. While the shareholders of these firm get higher expected returns on the operation, bondholders may suffer because of the additional risk. Empirical studies find that losses by bondholders are minimal. Laid-off workers Corporate raiders are often accused of laying off workers of the newly acquired firm. The argument is circular because the objective of the takeover is to improve the efficiency of the firm so that it converges to its optimal size. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 29 / 29