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Monopolistic Competition and Oligopoly

Monopolistic Competition and Oligopoly 11
Lecture 11 Imperfect Competition Business 5017 Managerial Economics Kam Yu Fall 2013Outline 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 Ecient Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 2 / 29Introduction Monopolistic Competition and Oligopoly We have so far studied two extreme forms of market structure. In perfect competition, no single rm has the market power to in uence the market price. In the long run rms make no economic pro t. A monopolist which sells a product with no close substitute enjoy great market power and makes economic pro ts in the long run. Most market structures in our economy are something in between. In monopolistic competition, each rm sells a di erentiated product with its market niche. The rms enjoy some market power and face their own downward sloping demand curves. In an oligopoly, price, quantity, and therefore pro ts depend on the interactions of the rm. The form of competition and market outcome are indeterminate. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 3 / 29Monopolistic Competition Market Power The market power of a monopolistic competitive rm depends on a number of factors: Number of competitors Production capacity of competitors Ease of new rms entering the market Degree of product di erentiation Brand name recognition and loyalty Price di erence awareness of consumers Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 4 / 29Monopolistic Competition ShortRun Competition A typical rm faces a downward sloping demand curve, with a steeper marginal revenue curve. Pro t maximization is achieved by setting MC = MR. The rm produces Q and mc charges P on the demand mc curve. Economic ineciency compared with the perfectly competitive market. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 5 / 29Monopolistic Competition LongRun Competition As long as the rms are making economic pro ts, new rms will enter the market. The demand and MR curves of a typical rm shift down because of increased competitive. Demand also becomes more elastic. This continues until all economic pro ts have eroded, with price P mc1 and quantity Q on the LRAC curve. mc1 Note that in the long run the rm is not producing at the minimum eciency scale, meaning economic ineciency. This occurs as long as the demand curve facing an individual rm is not perfectly elastic. Firms in monopolistic competitive often engage in nonprice competitive such as advertisement and customer relationships. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 6 / 29Monopolistic Competition LongRun Pro ts Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 7 / 29Oligopoly Modelling Reality Just a Handful of Sellers Typically just a few sellers in a market with not much product di erentiation. 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 deadweight loss is larger than that of a monopolistic competitive rm. 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 / 29Oligopoly Modelling Reality Oligopolist as a Monopolist Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 9 / 29Oligopoly 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 rms 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 meets the market demand c curve D at price P and quantity Q . m 1 2 Excess demand exists at any price below P , these excess demands 1 become the demand curve D for the dominant producer, with d corresponding marginal revenue MR . d The dominant producer maximizes pro t by setting MC = MR with the pricequantity combination (P ;Q ). d d The followers are price takers, now face market price P . The excess d demand between the consumers and the followers is Q Q , which 3 1 is equal to Q . d Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 10 / 29Oligopoly The Stackelberg Leadership Model Price Leader and Followers Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 11 / 29Oligopoly Collusion How Cartels are Formed If product di erentiation is weak, consumers are more price sensitive. Pricing becomes the main tool in competition among the oligopolists. There are strong incentives for the rm to form a cartel and behave collectively like a monopoly. The cartel chooses the monopoly pricequantity combination to maximize pro t, which is shared by its members. With the high monopoly price, however, each individual rm in the cartel has an incentive to cheat, making even more pro t 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 / 29Oligopoly Collusion An Example of Duopoly Two identical rms with constant returns to scale technology. They form a cartel to maximize joint pro t with (P ;Q ). This m m means each rm produces at a level Q =Q =2. 1 m After the collusion agreement, each rm has the incentive to lower price a little to P and 1 capture almost the whole monopoly market. But total pro t goes down if both cheat. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 13 / 29Oligopoly Collusion Back to Game Theory The above colluding duopoly can be described by a Prisoner's Dilemma model. Assume that the two rms, A and B, have two choices, high price or low price. Their incentive can be analyzed with the payo 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 rms, resulting in the inecient 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 oneshot 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 / 29Oligopoly Collusion Payo Matrix of a Duopoly Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 15 / 29Oligopoly Collusion Cartels with Lagged Demand Recall that when a product exhibits lagged demand due to network e ect or rational addiction, a rm 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 rm has the incentive to freeride the other rms. 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 / 29Oligopoly Collusion GovernmentSupported Cartels In a lot of cases the transaction costs of maintaining a cartel (negotiating, monitoring, and enforcing the agreement) is higher than the bene ts 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 ecient in maintaining a cartel. This is why some industries lobby for government regulations or oppose deregulation. The e ects 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 / 29Oligopoly Regulating Monopoly Natural Monopoly When the longrun average cost is declining within the range of market demand, it is cost e ective to have a single producer. The natural monopoly is socially inecient, however, if it exploits consumers with its market power. The government usually steps in to regulate the monopoly. Instead of the monopolist's pro t maximizing (P ;Q ), the m m government can impose a price ceiling at P , where the LRAC meets 1 the market demand curve. This may occur naturally without government intervention in a contestable market. Even though there is a high xed cost, some well nanced rms may see the monopoly pro t 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 ecient level at P . 1 Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 18 / 29Oligopoly Regulating Monopoly A Natural Monopolist Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 19 / 29Business 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 ineciency. Others try to explain regulation from an institutional economics perspective. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 20 / 29Business Regulation Public Interest Theory Regulating Cartels and Natural Monopoly Cartels and natural monopoly are common targets by government. The objective is to eliminate the deadweight welfare loss in the industry. Determining the exact values of the socially ecient pricequantity combination (P ;Q ), however, is not a c c trivial task. Cost structure of a monopolist is private to the rm. It has the incentive to mislead the government. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 21 / 29Business 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 ecient. 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 ecient output Q , the government can provide a subsidy to the rm equals to the 2 economic losses. This, however, gives the incentive to the managers to turn the subsidy into perks and increased pays. Unions members of the rm have the incentives to negotiate pay raise and more fringe bene ts. LRAC and LRMC will shift upward, raising market price and reducing output. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 22 / 29Business Regulation Public Interest Theory Underproduction and Government Subsidy Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 23 / 29Business 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: bene ts 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 Freeriding 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 speci c industries. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 24 / 29Market 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 rms 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 MA as horizontal or vertical integrations. Occasionally \corporate raiders" o er 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 / 29Market for Corporate Control Firm Integrations Managerial Monopolies Internal departments of a rm can behave like a monopoly, restricting services and requiring larger budget of operations. Management uses outsourcing as a tool to avoid ineciency of internal monopolies. If the management is unable or unwilling to tackle these ineciency, the company's stock value may become depressed. This provides incentive for an outside to take over the rm, improve its eciency, and resell it at a pro t. The threat of a hostile takeover keeps internal monopolistic behaviours in check. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 26 / 29Market for Corporate Control Firm Integrations Hostile Takeover and PrincipalAgent Problem In a classical principalagent situation, the objective of the management of a rm is not aligned with that of the shareholders. In a hostile takeover, the management always oppose the rm being taken over. The new owner of the rm threatens their pay, perks, and privileges. Often the management team will be replaced. The shareholders of the target rm, on the other hand, are the main bene ciaries 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 rm su ers from principalagent problems. Outsiders see the opportunity to improve the operation of the rm. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 27 / 29Market for Corporate Control Are Hostile Takeovers Ecient CostBene t Analysis of Takeovers The shareholders of the target rm usually gain from a hostile takeover. What about the other players Winner's curse Imagine that bidders of a rm have their own subjective evaluation on the value of the target rm. The one which wins the bid has the most optimistic outlook. The winning rm may overbid compared with the average bid. This may potential hurt the shareholders of the acquiring rm. Empirical studies do not support this argument, shareholders of the acquiring rm on the average gain 1 to 3 percent in their stock prices. Firms which actually su er 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 / 29Market for Corporate Control Are Hostile Takeovers Ecient Other Third Parties Bondholders A hostile takeover may increase the risk the target rms or the acquiring rm. While the shareholders of these rm get higher expected returns on the operation, bondholders may su er because of the additional risk. Empirical studies nd that losses by bondholders are minimal. Laido workers Corporate raiders are often accused of laying o workers of the newly acquired rm. The argument is circular because the objective of the takeover is to improve the eciency of the rm so that it converges to its optimal size. Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 29 / 29
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